REPORTS ON INFORMAL CREDIT MARKETS IN INDIA:

SUMMARY

A DAS-GUPTA

AUGUST, 1389

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NATIONAL INSTITUTE OF PUBLIC FINANCE AND POLICY 18/2 SATSANG VIHAR MARG

SPECIAL INSTITUTIONAL AREA NEW DELHI

NIPFP Library■■uni332.306054 D26R H9

PREFACE

The study of Informal Credit Markets in India presented here fonts part of a study o f Informal Credit in five developing member countries of the Aslan Development Bank. The study has been Initiated and funded largely by the Asian Development Bank. It was funded partly by the National Institute of Public Finance and Policy (NIPFP). The study has been carried out at the NIPFP, New Delhi and at the Centre for Development Studies (CDS), Trivandrum. The NIPFP carried out the study of urban markets and the CDS of rural markets. The NIPFP was entrusted with the task of coordinating and Integrating the main findings o f the study. Part o f the study done by the. NIPFP was undertaken jo in tly in collaboration with State Bank of India.

The project coordinator for the NIPFP study was A. Das- Gupta who took over the task from Srinivasa Madhur shortly after its commencement. C.P.S. Nayar coordinated the fie ld work in South India for informal institutions dealt with in chapters 18 to 23 and 26 of the report. A. Das-Gupta coordinated the fie ld work for the remaining chapters. Research and fie ld personnel associated with the project were, M.L. B ijlan i, K.S. Dinesh, Thomas Gomez, A. K. Jain, S. Kumar, Krishnamurthy Maya, Sadhna Marwaha, K. Mathai, Sanjeev Mohanty, Hiranya Mukhopadhyay, A.L. Pandya, P.K. Gopalakrishnan Nair, N. Parameswaran Nair, J.K. Pandey and S. Radhakrishnan. They have our grateful thanks.

The NIPFP project coordinator Dr. Das-Gupta had overall responsibility for the urban and summary reports and has written or revised a l l material in these reports. The urban study was planned and for most part conducted by him. First drafts o f some chapters in the urban report were prepared by the fo llow ing persons.

1. C.P.S. Nayar : Chapters 18 to 21, 22 (the South India casestudy), 23 (the South India case study) and 26 (w ithS.Sadhakrishnan).

2. Krishnamurthy Maya : The Delhi case study in Chapter 22.

3. Sadhna Marwaha: Chapter 33 and the Appendix.

4. Hiranya Mukhopadhyay : Chapters 24 and 31.

5. J.K. Pandey : Chapters 27 and 28.

C.P.S. Nayar has primary authorship for the chapters to which he has contributed. Sadhna Marwaha, Hiranya Mukhopadhyay and J.K. Pandey are the primary authors o f the appendix and chapters 24 and 27 respectively.

The focus of the study is on the operation o f Informal Credit Market (ICM) in India and its role and impact from the angles o f efficiency in resource use, social Justice and efficacy of monetory control. The authors have ma<fl| painstaking e ffo rt to provide an idea o f the working of the ICM in India, based on a

survey of selected sectors. Secondary data have also been used wherever found relevant and useful. An attempt has also been made to estimate the size of the I CM, though very tentatively. The study brings out several aspects of the operation of the ICM which were re lative ly neglected in previous studies on the subject such as the possible significance of unaccounted Incomes ln funding the ICM and the importance of the market structure. It also briqgs to light the sources and uses of funds in a number of sectors not covered in past researches. An important finding of the study Is that even after the rapid expansion o f banking services in the country a fter nationalisation of the major banks in 1969, the ICM continues to finance trade and business activ ities ln a big way, and not merely in the unorganised secto r. Some o f the case studies documented here also reveal that existing regulations governing the functioning of the ICMs leave much to be desired.

It ls hoped that the findings and conclusions of the study w ill be of interest to a wide audience.

The Governing Body of the In s t itu te does not take any responsibility for any of the views expressed in the report. That responsibility lie s primarily with the authors.

New Delhi Amaresh BagchlAugust, 1989 Director, NIPFP

ACKNOVLBDGEMEHTS

In carry ing out th is study of urban informal cred it markets, the project team has profited greatly from the help and advice of a number o f persons and in stitu tion s whom It is my pleasant duty to acknowledge.

■4

The NIPFP team wishes to thank Amaresh Bagchl for going through d ra fts o f several chapters and o ffe r in g va luable suggestions. Special thanks are due to T.N. Srin ivasan , the referee of this report at the fina l workshop on informal credit markets held ln Manila ln March, 1989, for his detailed comments on the draft report. Also, the NIPFP project team would like to thank S. Radhakrishnan for his association and for providing data on nidhis. Thanks are also due to other partic ipants at the workshop, to Srinivasa Madhur the former project coordinator, and to Sudlpto Mundle, Mihir Rakshit, Shovan Ray, Amal Sanyal and partic ipan ts o f seminars at the East-West Centre, Harvard Institute for International development, Rutger University and the NIPFP for helpful comments and suggestions.

We also take this opportunity to thank Prabhu Ghate of the ADB for his encouragement and patience.

Generous help from various government and bank o ffic ia ls , o ffic ia ls of associations of intermediaries, traders or producers, researchers and others was received during the course of our in vestigation s. While they are too numerous to acknowledge individually they have our grateful thanks. However, we would especially like to thank Thomas Tiraberg and Chandrasekhar Aiyar for their advice early during the project and for making available copies of background material for their celebrated study.

None of those acknowledged can be held responsible for shortcomings in the report the responsibility for which rests with the authors.

The NIPFP project team is also grateful to the sta ff of the NIPFP Computer Centre for assistance and to K. Subramanian and N. Natarajan for secretarial assistance.

Finally, the NIPFP project team is immensely grateful to Promila Rajvanshi who coordinated correspondence, word processing of the report/questionnaires and report production work from the inception of the project with efficiency and cheerfulness.

A. DAS-GUPTA Project Coordinator

CONTENTSPage

Preface i •

Acknowledgements i l l .

PART A : 1: Overview o f the Urban Study 1

PART B : Description o f Urban Indian Infom al Credit andInfom al Credit Markets

2. Infomal Credit and Infom al Intermediaries 83. Deposit Mobilisation Activities and Sources

of Funds14

4. Uses of Funds 195. Tems of Loans and Credit Appraisal Methods 256. Cost of Intemediation 287. Structure of Infom al Markets 388. Size and Trends in Size 459. Regulation of Infom al Intemediaries 58

PART C: Analysis of Economic Impact of In fom al Credit Markets

10. Infomal Credit and the Efficiency of Resource 63Allocation

11. Equity Impact o f Infom al Finance 7112. Are Infomal and Fomal Finance Complements or 75

Substitutes ?13. Infomal Credit and Monetary Policy 7814. Two Issues: The Complementarity Hypothesis 85

and Links with the Black Economy

PART D : 15- Infom al Credit Markets in Rural India 89

PART E : Policy Prescriptions

16. Lessons for Fomal Banking and Recommendations 116for Regulation.

BIBLOGRAPHY 121

APPENDIX: CONTENTS OF DETAILED REPORTS AND PREFACE TO THE CDS REPORT

PART A

OVERVIEW OF THE URBAN STUDY

OVERVIEW

1.1 Objectives

1.1.1 The objectives of th is study o f urban in fom al credit in

India are:

1. to derive estimates o f the size and importance o f infom al cred it,

2. to examine the informal credit market structure and the Impact o f government regu lation on informal c red it markets,

3. to examine the impact o f Infom al credit on allocation, distribution, growth and the effectiveness o f short run macro policy, and

A. to make policy suggestions as to regulation o f infom alcredit markets and formal sector credit operations.

1.2 Definition o f informal credit adopted

1.2.1 The concept o f in fom al credit used in this study roughly

corresponds with the concept ' non-instltutlonal c red it ' used by

the Reserve Bank of India (RBI) in its surveys o f households. It

excludes banks of a l l types, government financial institutions,

housing finance institutions and the organised capital markets for

shares, debentures, fixed deposits and government bonds. For the

remaining sources o f finance, a l l are (potentia lly ) taken note of

when analysing the sources o f credit o f credit using sectors. A

selection of infom al intermediary sectors is also covered in this

study. Finally, i f credit users are also suppliers o f credit,

th is Is taken note o f to assess th e ir net c red it position .

However, a systematic attempt to study sources o f supply of

study.

1.2.2 The defla itlon o f in foraal credit la aotlvated p r la a r lly

by considerations o f government regu la tion . I a p l lc l t ly , the

notion o f the foraal sector which we aeek to capture Is o f that

portion o f financial markets which are effectively subject to

governaent control In the Batter o f a llo ca tion o f c red it and

deposit aobillsation . In particular financial institutions which

are d irectly affected by central bank short run aonetary policy

aeasures, including among these aeasures, reserve requirements and

selective credit controls, are c la ss ified ss belonging to the

formal sector. Attempts by the government to curb money supply

growth or to curb credit a v a ila b ility for different purposes and

to d ifferent sectors w ill have their primary impact on what we

c la ss ify as formal credit markets.

1.2.3 While this does not imply that informal credit markets are

entire ly beyond central bank regulation, the extent o f direct

control over activ ities o f Informal lenders and intermediaries is

substantially less than that o f formal intermediaries. As shall

be described, controls are limited to licensing, Interest rate

c e i l in g s , re s tr ic t io n s on deposit taking and reporting

requirements for even the most highly regulated informal credit

su p p lie rs . The d e fin it io n adopted here has the add it ion a l

advantage o f d ove ta ilin g with the d e fin it io n o f inform al or

unorganised credit used in e a r lie r examinations o-f credit markets

in In d ia . In p a r t ic u la r , we aay mention studies by various

government committees and by the World Bank (see the references at

the end o f the report).

1.3 Coverage

1.3.1 A tota l o f 6 credit using sectors, 9 Intermediary sectors,

1 In tegrated cred it aarket, 2 cases of l i t ig a t io n by the

government and 3 Reserve Bank o f India Surveys of households and

f lra s are covered In th is study. The credit using sectors were

chosen on the basis o f where ea r l i e r work or discussions suggested

the prevalence o f informal cred it . However, at least one sector,

garment exports, was chosen to examine conditions in a sector

which, being in the vanguard o f export promotion e f f o r t s , i s

thought to be wel l served by the formal sector including, in th is ,

f i s ca l incentives. Secondly, sectors dealing with food products

were excluded, though 'c lo th in g ' and ' s h e l t e r ' are represented.

While the bulk o f informal credit from intermediaries is covered

on a sample basis, certa in interesting in fom a l credit segments,

such as the leasing industry, pawnbrokers and ba i l bond brokers,

remain uncovered. The samples used in the various sectoral studies

are given in Table 1.1. The tota l number o f units surveyed (from

which q u a n t i t a t i v e in format ion was ob ta ined ) was 415. In

addition, over 200 interviews with bank and government o f f i c i a l s ,

o f f i c i a l s o f informal intermediary associations and producers

associations and also other knowledgeable persons were conducted.

The i n i t i a l sample designs were however, in several cases, larger

than given in Table 1.1. These were reduced due to non-cooperation

o f in terv iewees.^" The q u a l i t y o f in t e r v i ew data va r ied from

sector to sector but is on the whole, acceptable. Questionable

data, when used, i s ca re fu l ly noted in the case studies. The

secondary data sources covered between them over 1 lakh units (1

lakh equals a hundred thousand and one crore, used la te r , equals

ten m i l l i o n ) . F in a l l y , the l e g a l case study is based on

newspaper reports, court transcripts, company f inanc ia l statements

and an RBI repor t .

1.4 Analysis

1.4.1 In view o f the small sample size for each sectoral study,

only means, variances, corre lat ions and rat ios have been computed.

More sophisticated s ta t i s t i c a l analysis has been eschewed, except

for a so l i ta ry regression. In one case, a mathematical model has

1. In the c a s e o f H o u s in g F i n a n c e , th e sam p le s i z e q u a n t i t a t i v e i n f o r m a t i o n dropped from 25 to 0! A l s o , in case o f f i l m f i n a n c e no q u a n t i t a t i v e da ta was p ro v id ed in t e rv i e w e e s .

fo r the

by

been constructed on the basis o f s ty l ised facts drawn from the

f i e l d study. More sophisticated analysis has been attempted only

in the chapters dealing with RBI surveys. This i s , o f course, a

l im i t a t i o n o f our work which may be seen to have breadth o f

coverage rather than great depth in view o f the comprehensive

terms o f reference and the l imited time at our disposal.

1.5 Main findings

1.5.1 While these are g iven below in the next two p a r t s , we

b r i e f l y indicate the major conclusions here, while reminding the

reader o f their tentat ive nature in view o f the small sample sizes

and the cross section nature of the study.

a. Inforaal deposit interest rates generally exceed formal sector rates as do loan rates o f informal intermediaries. However, given the importance o f credit from friends and r e l a t i v e s , the average cost o f borrowing in the productive sectors studied in this report, fo r informal credit users is lower than the average for a l l units taken together (Chapters 2 and 4 ) .

b. Though credit is fungible making i t d i f f i c u l t to determinethe extent to which loans for a given purpose are actual ly vised for that purpose, informal credit Ls la rge ly used for productive a c t i v i t i e s ( r a th e r than consumption) and,in c lu s iv e o f t rade c r e d i t , i s the dominant source o fcredit for a l l productive sectors studied (including the RBI surveys). However, loans from informal intermediaries are unimportant to a l l but one productive sector studied. That they are c lea r ly o f importance to such sectors as transport operators and handloom weavers emerged in the course o f s tud ies o f in te rm ed ia r ie s (Chapter 3 ) . Furthermore, even for c red it from informal intermediaries, loans are la rge ly fo r production or trade.

c. Monopoly p r o f i t s are not an important component o finformal lending rates for the major types o f informalintermediaries in urban India (Chapter 6 ) .

d. Informal credit markets are generally at the competitive end o f the spectrum o f market types. Fragmentat ion, de f ined to be a s i t u a t i o n where in t e r e s t ra te d i f f e r e n t i a l s for s im i la r loans to s im i la r borrowers persist is present due la r g e ly to informational obstacles (Chapter 7) .

e. Aggregate informal c red it forms about 73% o f gross bankcred it (at a conservative estimate) though operations o f

informal intermediaries are much less important (Chapter 8).

f - The evidence suggests that in some case informal creditpromotes e f f i c i en cy o f resource a l locat ion though negative and inconclusive evidence has been found in other cases.The evidence supports the view that informal credit serveseconomically weak sections r e la t i v e l y more than formal c red it (Chapters 10 and 11).

g. That informal cred it is , by and large, complementary tobank f inance , g iven current banking p r a c t i c e , f indssupport from the data from case studies, though not from the RBI surveys o f f i rms. Informal c r e d i t is said to complement bank cred it when they serve d i f f e r en t groups ofborrowers or are used for d i f fe ren t purposes so that thetwo sectors are not in competition for the same custom. I t is poss ib le that informal c r e d i t lowers short runmonetary po l icy e f fec t iveness , though there is less reason to be l ieve that i t renders i t t o ta l l y impotent (Chapters 10 and 11).

h. The hypothesis o f f inancia l repression finds some support from the evidence (Chapter 12).

1.5.2 The fo llowing eleven points provide a summary o f other

conclusions reached from our study and a lso the main p o l i c y

recommendations.

1. In formal loans show g r ea te r d i v e r s i t y and read ier adaptabi l i ty to borrower convenience than formal loans.

2. The average and maximum duration o f informal loans are less than formal loans (though not necessarily commercial bank loan s ) .

3. Informal credit assessment and loan sanctioning procedures are speedier than formal procedures.

4. The range o f a c t i v i t i e s financed by the informal sector is greater than the range financed by the formal sector.

5. To the majority o f households and unorganised enterprises, informal loans are the main source o f borrowed funds.

6. Informal c red it is more important for working capita l and c a p i t a l maintenance finance than for f inanc ing the purchase o f cap ita l goods.

7. Informal cred it agencies have an absolute and comparative advantage in the provision o f cred it to small a c t i v i t i e s .

8. Due to informational disadvantages and extant technologies for making payments for goods and serv ices, modern banking may not be able to replace informal c red i t in the medium term even with complete f inancia l l ib e ra l i s a t ion .

9. Optimal p o l i c y f o r formal agenc ies r e q u i r e s them to confine t h e i r d i r e c t a c t i v i t i e s to depos i t taking and lending only where they have an advantage. Methods o f refinancing informal credit agencies should be devised in order to ensure e f f i c i e n t c r e d i t d e l i v e r y to o ther a c t i v i t i e s .

10. Regulation o f urban informal credit should be directed at :

( i ) Ensuring improved information about informal credit and informal intermediaries.

( i i ) Ensuring the f inancia l probity o f informal in te r ­mediaries. Such measures should be designed sepa­ra te ly for r e l a t i v e l y homogenous groups o f in ter­mediaries and should err, i f at a l l , on the side o f non-interference with the e f f i c i e n t functioning o f informal f inancia l markets.

11. When required, monetary control can be exercised by the central bank by varying the rate at which refinance is avai lable.

1.6 Organisation

1.6.1 This summary report is divided into 3 addit ional parts.

Part B contains short chapters which describe sal ient features of

urban informal c red i t . Part C contains chapters in which findings

on the economic impact o f urban informal c red it are discussed.

Part D has a s e l f contained summary o f the companion study o f

rural informal c red i t markets. Po l icy suggestions are in Part E.

Staple Chincteristics for Sectors Studied

Sector Secondary data source for financial data Field data

Naae Year Location Saaplesize

Location Saaple size

Intermediary Sectori

1. Finance corporations Nayar(1984) 1982 All India 450 South India 42 companies31 users

2. Chit funds RBI(1) See noted) 1866 South India 37 chit funds42 aeabers

3. Hire purchase (1) RBI(I) See noted) 481 South India 30 HPFFIHPAI2) 1986 Madras city k 1118 and Delhi 12 borrowers

surrounding areas4. Nidhis RBIil) 1986 See note 65 Taail Nadu 1 12

i Andhra Pradesh(2)Raiani(1985) South 1344

S. Auto financiers Local Ass. 1986 India Naaakkal (T.N) IBof financecorporations

6. Handlooa Financiers - - Karur / Bangalore 107. Shroffs of Western India Boabay 198B Western India N.A. -

ShroffsAssociation

8. Intercorporate funds aarket “ Hetro Cities 60

Credit Using Sectors

1. Road construction - Delhi and 35Western U.P.

2. Garaent exporters - Delhi 193. Fila finance - Madras -4. Powerloo* units - Surat(Gujarat) 18S. Textile wholesale trade Jain et.al.(19B2) 1979 All India 950 Boabay 376. Housina finance of households V.D. Lai 1(1984) 1984 All India 728 - -

RBI Surveys1. Households RBI 1981-82 All India 31014 - -

2. Saall Scale Industrv RBI 1976-77 All India 12356 - -

3. Traders RBI 1979-80 All India 12057 - -

4. Transoort ooerators RBI 1979-88 All India 6129 - -

TOTAL 415

2. Federation of Indian Hire Purchase Association.3. Over 288 interviews were also conducted to elicit qualitative information.

PART B

DESCRIPTION OF URBAN INDIAN INFORMAL CREDIT AND INFORMAL CREDIT MARKETS

URBAN INFORMAL CREDIT AND INFORMAL INTERMEDIARIES

2.1 Introduction

2.1.1 Urban informal c r e d i t , in formal in te rm ed ia r ie s and

"unorganised" money markets in India have been examined in the past by

various government bodies and scholars (see the references at the end of

the report ) . Recent government committees to study informal credit have

been the Banking Commission (1971), James Raj Committee (1975) and the

Reserve Bank of India (Chakravarty Committee) (1985). Among recent

studies by individual scholars, Karkal (1967), Nayar (1973, 1982 and

1984), Radhakrishnan (1975) and Timberg and Aiyar (1980) are the best

known. A detailed review is in the appendix to the report. In this

chapter a b r ie f guide is provided to the types o f informal credit and to

participants in informal credit markets in urban India.

2.2 Trade credit

2.2.1 Perhaps the most prevalent form of credit in the economy is

through credit sales or through advance payment for goods purchased,

the two together are c o l l e c t i v e l y known as trade c red i t . The former is

t yp ica l l y re f lec ted in the b i l l s receivable and b i l l s payable accounts

o f f irms. Such cred it is obviously not intermediated by specia lised in­

termediaries. Furthermore, trade credit is by de f in i t ion interlinked

with a transaction on a particular goods market. Most other major forms

o f informal credit except for loans between friends and re la t iv es in­

volve intermediation.

2.3.1 A v a r ie ty o f cred it Instruments ex ist ln urban Informal

market8. These are discussed more fu lly in the main report. The most

fin an c ia l Instrument, which was much in use t i l l recently , l s the

'h u n d l ', a form o f demand or usance b i l l which has been in use to

finance interregional and international trade for centuries. Several

types of hundls were and are in use particularly by shroffs. Other

methods of provision o f credit are though the discounting of post dated

cheques, trade b i l ls and waybills (lorry/railway receipts), and so on.

Among these instruments, hundis issued by bankers with sound reputations

were highly liquid ln that they were readily accepted ln certain busi­

ness in settlement o f claims. No other indigenous instrument appears to

have th is p a rticu la r 'n ea r money' ch a rac te ris t ic . Hundls (th e

'darshani' hundi of Gujarati shroffs) are also considered a cheap and

risk free way of making remittances. Among depositing instruments, the

' sarkat' employed by Rastogi bankers' is described by Timberg and Aiyar

(1980).

2.4 Informal intermediaries and lenders

2.4.1 There are several types of informal intermediaries and lenders

in India and much diversity in the kinds of transactions undertaken by

them. Ten types of intermediaries and lenders, chit funds, finance cor­

porations, hire purchase firms, nidhis, (shipping) clearing agents, in­

tercorporate brokers, textile wholesalers, aratlyas, angadiyas and

shroffs in Western India have been studied in greater detail. B rief

descriptions of the important types of intermediaries at present are now

given.

2.4.2 Chit funds: These are indigenous rotating savings and credit or­

ganisations. While chit funds are prevalent among household and small

businesses a l l over India, chit funds are also organised by chit fund

firms, especially in South India.

note, which ls used exten-

Shroffs. An indigenoussively by Finance Companies and Shikarpurl Shroffs.

2.4.3 Finance corporations: These institutions have activ ities essen­

t ia lly similar to commercial banks except for non-issuance of cheques

and no provision of funds transfer services.

2.4.4 Hire purchase firms: Such firms are generally active in vehicle

and durable finance, specialising in market segments not served by com­

mercial banks. Most such firms accept deposits from the public.

2.4.5 Nidhis: These are single branch inst i tut ions similar to credit

unions. They are found mainly in South India. Much o f the ir credit

goes to f inance investment in housing.

2.4.6 Clearing agents: Also known as dockyard financiers or railyard

financiers they g ive short term accommodation to the ir c l i en ts .

2.4.7 Wholesalers and other intermediaries ln the distribution of

goods: Such agents typ ica l l y combine sale o f goods with (t rade) credit .

The volume o f f inance by such agents is large re la t i v e to the to ta l size

o f credit markets.

2.4.8 AratLyas or commission agents: Act as Intermediaries between lo ­

cal and outstation traders in chains for the d istr ibut ion o f goods.

They intermediate large fractions o f to ta l outstation sales in many com­

modity markets and provide financial accommodation to the ir c l ients.

Their main ro le however Is in reducing Information costs o f both buyers

and se l l e r s .

2-4.9 Angadias: S tr ic t l y , these agents are not purveyors o f cred it .

However they play an important complementary role in f a c i l i t a t in g funds

flows between d i f f e ren t centres at costs much below that o f banks.

Aiyar (1979) holds that they are also important agents In the under­

ground economy.

2.4.10 Indigenous bankers or shroffs: These age old Indian inst i tu­

tions serve business, usually trade. They are grouped into various

types (Multanis, Shikarpuris, Gujaratis, Shekhawatls, Rastogls, Marwarl

Kayas, Chettiars, e t c . ) along community ILnes and operate in d i f fe ren t

parts o f India. Among the major groups, Chettiars In South India have

almost disappeared.

2.4.11 Brokers: There are a bewildering array o f brokers in informal

markets whose main and sometimes only ro le i s informational. Timberg

and Aiyar (1979) have studied Shlkarpuri brokers in some depth. In ter ­

corporate brokers and black money brokers (Aiyar 1979) are other impor­

tant types o f brokers. Unusual though minor segments such as bail-bond

brokers are also to be found. Many large brokerage houses combine

various functions and others are gradually l im it ing th e i r business to

(formal market) stock-broking. The intercorporate funds market has been

examined by the Chakravarty Committee (1985).

2.4.12 Leasing companies: Due primarily to the tax code, there has

recently been a sharp increase in the number o f equipment leasing firms

and the volume o f f inancial leases, enabling companies to engage in o f f

balance sheet capita l finance. Some commercial banks have also started

leasing subsidiaries in competition with informal leasing companies.

2.4.13 Pam brokers: They have been examine by Aiyar (1979). Found

mainly in South Ind ia , they both accept depos i ts and provide pawn

finance. Aiyar estimates a to ta l volume o f loans between Rs 250 crore

and Rs 300 crore in 1979. However the ir business has adversely been a f ­

fected by Pawn Brokers Acts and Debt R e l i e f Acts passed in the 1970s.

Many pawnbrokers in South India are from the Chett iar community (Aiyar

1979).

2.4.14 Money lenders: While not as widespread as in rural areas, money

lenders who re ly primarily on the ir own cap i ta l , are to be found in

various parts o f India.

2.4.15 *Piggy back' intermediaries: These informal intermediaries are

o f recent vintage and come in various forms, the ir essent ia l charac­

t e r i s t i c being close association with formal c red i t markets. Along

trad it iona l l ines , there are bank loan brokers who undertake to obtain

bank loans In the ir own or c l i en ts names for business c l i e n t s for a fee.

Obviously, such brokers have found the means o f circumventing banking

sector credit controls in some way. More innovative are firms which un­

dertake to pay premiums for endowment type l i f e insurance policies in

return for one or more payments during the in it ia l years of the policy.

Thus for example, i f total premium payments over 20 years are Rs 10,000,

the insurer may be asked to pay Rs 6000 over 3 years to the firm.

2.4.16 Investment and loan companies: Investment companies are essen­

t i a l l y mutual funds in the company sector. Many o f these are simply

holding companies or investment subsidiaries o f large industrial houses.

The RBI designation ' loan company' includes many government finance in­

st i tu t ions . Some firms use this designation while awaiting sanction to

start h ire purchase firms, Nidhis and so on. Therefore, loan companies

are not, s t r i c t l y speaking, informal lenders. Investment companies do

f a l l under our de f in i t ion o f informal lenders (with the exception o f the

Government owned Unit Trust of India ) . Some o f their a c t i v i t i e s are

ind ir e c t ly studied in the chapter on the intercorporate funds market.

Nayar (1984) makes a detai led study o f these firms.

2.5 Regional informal markets

2.5.1 This study o f informal cred it markets has adopted a sectoral

approach. Thus, except in a few instances when the major markets were

geographically concentrated, no de ta i ls o f character is t ics o f markets in

d i f f e r en t centres are given. In the course o f Investigations a few In­

terest ing features o f markets in d i f f e r en t centres have been covered.

Two interest ing cases are worth reporting.

2.5.2 Trade finance in Calcutta, the raost secret ive major trading

centre, i s reportedly control led, in the main, by a few syndicates o f

lenders organised along community l ines . We had no success in discover­

ing much about these syndicates. A story told to th is researcher was

how the head o f a major Indian business house was kept waiting in an an­

teroom for hours by the head of a syndicate before he was allowed to

meet the head and ask for a large short terra loan (Rs 8 crore) . I f

true, th is r e f l e c t s great market power on the part of these syndicates.

2.5.3 Brokers exist In various markets to intermediate between in­dividuals and traders in need of working capital Aiyar (1977). In Surat

such Individuals include doctors, lawyers, government servants and so

on. Loans there reportedly fetch interest of 2.5 to 4 per cent per

month for 30 to 90 day loans.

DEPOSIT MOBILISATION AND SOURCES OP FUNDS

3.1 Sources o f funds o f Internedlarles

3.1.1 Data in Tiraberg and Aiyar (1989) show that except for Mul-

tani Shroffs, deposits formed the main source o f funds o f informal

leaders. In our study except fo r c learing agents, the mala dock­

yard financiers io Calcutta, deposits from individuals are the

raaia source o f funds for a l l interraediaries studied. Own funds are

the main source of funds for clearing agents and the second most

important source o f funds for hire purchase firms in Delhi. Own

funds are r e l a t i v e l y more important for hire purchase firms that

are not in the company sector as compared to those in the company

sector, though deposits form the bulk o f resources. Limited formal

funds are d i r e c t ly or ind irect ly avai lable for dockyard financing

and for hire purchase. There is some evidence of diversion o f bank

finance to the intercorporate funds market and also some evidence

o f inflows o f funds from informal intermediaries to th is market.

Own funds formed a similar ly small fract ion o f to ta l resources o f

finance corporations and chit funds. A summary o f sources o f funds

Ls given in Table 3-1.

3.2 Pattern of deposits with intermediaries

3.2.1 Call deposits, terra deposits and spec ia l ly designed saving

schemes are a l l used to mobilise deposits from Individuals- The

use o f recurring deposit schemes in India was pioneered by Nidhis

in 1882, while Peerless has managed to mobilise phenomenal amounts

o f small deposits through i t s endowment c e r t i f i c a t e scheme (Rs. 6

b i l l i o n in 1984). The period o f deposits vary from deposits on

ca l l to ten year deposits. Brokerage is paid by hire purchase com­

panies to brokers obtaining deposits for them. That brokers in

some regional markets who take a commission from individual

lenders for arranging borrowers ex ist , has been pointed out ear­

l ie r (Aiyar (1979), Timberg and Aiyar (1980)).

3.3 Deposit ceilings

3.3.1 Most types o f intermediaries in the company sector are

subject to controls on deposit taking, deposit interest rates and

on the duration for which they can accept deposits. Deposit c e i l ­

ings are usually spec i f ied as a ra t io to own funds (share capita l

and reserves ) . A few are also subject to "reserve requirements'' in

that there are st ipulations on the minimum rat io o f deposits which

has to be invested in speci f ied secur i t ies . Firms and individuals

not in the company sector face r e s t r i c t i o n s on the number o f

depositors they can have. Chit funds are covered by specia l ,

though broadly similar, regulations and there is a f i v e year c e i l ­

ing on the duration o f ch its , though th is is under appeal in the

courts .

3.4 Deposit interest rates

3.4.1 Deposit interest rates vary between 6.7 per cent per year

( f o r Peerless: now s ta tu to r i ly increased to 10 per cent) and 21

per cent per year ( f o r auto finance and handloora finance firms) .

Except in the case o f Peerless, some evidence o f rates o f interest

varying pos i t i v e ly with the period o f deposits ex is ts . In one

case, hire purchase, interest rates c e i l in g prevented higher in­

terest rates from being o f fered, though "under the table payments'’

in th is case cannot be ruled out- The now defunct Sanchaita In­

vestment paid interest at the rate o f 48 per cent per annum, three

quarters of which was not accounted for . The median rate exceeds

the maximum rate o f interest on commercial bank f ixed deposits,

which is currently 11 per cent per annum for deposits of 3 years

or more. Chit funds pay average rates estimated at between 10 and

16 per cent per annum. However, i t is d i f f i c u l t to dist inguish be­

tween borrowers and lenders s o l e l y from f in a n c ia l d e t a i l s o f

ch its . Detai ls o f interest rates are in Table 3.2.

3.5.1 Reserve Bank of India statistics show that deposits with

Nidhis, Chit funds and hire purchase companies have been growing

faster than bank credit in the eighties though aggregate deposits

with informal intermediaries continue to remain small relative to

the formal sector (See Chapter 8 ).

Sources o f funds o f surveyed s e c to r s

( p e r c e n t a g e o f t o t a l l i a b i l i t i e s )

S e c t o r Own f und s

Bankloan s

D epos i t s/o t h e r

s o u rc e s

F inance C o r p o r a t i o n s 9 N i l 91Chit Fund Companies 2 N i l 98N id h is 6 N i l 94H i r e -p u r c h a s e 13 4 83Auto f i n a n c i e r s 25 N i l 75Handloom f i n a n c i e r s 0-5 N i l 95-100S h r o f f s o f Western In d ia 25 N i l 75

S e c t o rOne yea r

o r l e s sMore than

one year

1. Finance C orporations( a ) D ep o s i t s 9 - 1 2 16 - 21( b ) Advances 48 - 16778 24 - 48

2. Chit Funds *)( a ) D e p o s i t s ( a v e r a g e a c r o s s 10 - 16*

member s ) *%( b ) Advances ( a v e r a g e a c r o s s 21 - 25*

member s )3. H ire -p u rch ase

( a ) D e p o s i t s ( i ) South In d ia 14 - 16 14 - 22( i i ) D e lh i 12 14

( b ) Advances ( i ) South I n d ia - 28 - 38( i i ) D e lh i - 28 - 41

4. Dockyard F in an c ie rs (A dvances) 605. H idh is

( a ) D e p o s i t s 9 - 1 2 16 - 22( b ) Adv anc e s - 16 - 23

6. A u to -fin an ce (Nam akkal)( a ) D ep os i t s 1 9 21( b ) Advances - 40

7. Hand loom F in an c ie rs(B an ga lo re and K arur)

( a ) D e p o s i t s 18 20( b ) Adv ance s 44 - 68 -

8. S h ro ffs o f Western In d ia( a ) D e p o s i t s 8 - 1 4( b) Advances 18 - 21

9. Commercial Banks( a ) D e p o s i t s 8 - 9 9 - 1 1( b) Advances 16.5

No te : 1. The i n t e r e s t r a t e 16778 per cent per annum i s f o r a d a i l yloan a t 5 per cent per day assuming 100 w o rk ing days per annum.

2. ' I n t e r e s t r a t e s ' o f c h i t funds a re the net p r e s en t v a lu e s per rupee in v e s t e d at a d i s c o u n t r a t e o f 11% p lus 11%. No c o m p l e t e l y s a t i s f a c t o r y method o f e s t im a t i n g i n t e r e s t r a t e s has been found f o r c h i t funds .

DEPLOYMENT OF INFORMAL CREDIT

4.1 Sectoral deployment o f funds o f Interaedlaries

4.1.1 The experience here is quite varied.

a. Hire purchase firms provide finance primarily fo r new and used commercial vehic les through one to four year h ire purchase agreements. Hire purchase firms also finance consumer durables and non-commercial veh ic les .

b. Handloom financiers, o f course, provide working capita l finance for production by handloom weavers in the unor­ganised sector.

c. Finance from Nidhis i s ava i lab le mainly to households, though small business is also financed. The bulk o f loans goes to finance the construction, renovation and repair o f houses and other buildings. Loans may be for as long as seven years.

d. P e e r le s s inves ts much o f I t s d epos i t s in governmentsecurit ies and term deposits with nationalised banks.

e. In t e r c o rp o ra te loans average three to s ix months f o r private sector corporations and six to twelve months for public sector corporations.

f . Chit funds mainly f inance trade, s e l f employed persons,agr icu l tu ra l is ts and, to a l imited degree, consumption.

g. Shroffs in western India la rge ly f inance domestic trade through 'hundis' , though they also finance exports and industry.

4.1.2 The main point to note in this deployment o f credit is

that consumption loans form a small part o f informal c red it . Tim­

ber and Aiyar (1980) provide data showing that finance for trade,

export and industry make up the bulk o f informal c red it except for

that from pawn brokers and finance corporations- Summary informa­

tion is given in Table 4.1.

4.2 Bad debts and overdues

4.2.1 Bad debts were reported in the intercorporate market, in

auto finance in Namakkal, ia chit funds and with Shroffs and in

textile distribution. Except for the intercorporate market, here,

most cases were more in the nature of delayed payments rather than

outright d e fau lts . Furthermore, auto financiers are ab le to

repossess vehicles from defaulting borrowers. Bad debts in other

sectors were negligible. Thus recovery problems do not tie up a

lot of available informal funds, except in the case of shroffs who

claimed bad debts of between 5 and 10 per cent of earnings and

chit funds who had 7 per cent bad debts on average (about 1 to 2

percent of loans for the former and less than one per cent of chit

capital for the la tte r ). Even this level is , reportedly, low com­

pared to commercial banks.

4.3 Importance o f informal credit to productive sectors studied

4.3.1 One sector, f i lm finance in Madras, is almost wholly de­

pendent on informal f inance. Trade credit proved to be the most

important external source o f finance for the productive sectors

studied, espec ia l ly for the smaller firms (where a small/large

categorisation was f e a s ib le ) . However, owners' capital is the

dominant source o f finance in road construction. In t e x t i l e dis­

tr ibution, trading agents (wholesalers) re ly more on own funds

than non trading agents (brokers and commission agents). While it

was learnt that finance from professional f inanciers is the main

source o f finance for road construction contractors in Kerala,

pure informal intermediaries played next to no ro le in any produc­

t ive sector studied. Informal credit from friends, re la t iv es and

other associates was, however, o f importance, being more important

than bank finance in road construction and t e x t i l e d istr ibution.

Whether such funds rea l l y r e f l e c t informal finance or represent

i l l e g a l funds is not ascertainable for individual firms but are,

in a l l probabi l i ty , la rge ly i l l e g a l funds in the aggregate given

that we estimate such funds to exceed net household sector dues

receivable as estimated by the RBI (1987). However, that in for-

mal f inance plays a dominant r o l e In the f inance o f handloom

weavers and used truck operators was ascertained from studies o f

In te rm ed ia r ie s . That bank f inance Is not the main source o f

f inance even to garment exporters, despite various export Incen­

t i v e s and concessions, i s reveal ing. Formal credit i s more impor­

tant only for households ( including for house construction) and

perhaps for transport operators.^ Detai ls are in Table 4.2.

4.4 Inequality o f c red i t d istr ibut ion

4.4.1 According to data from the RBI surveys, informal credit

i s more evenly distr ibuted between households in d i f f e r en t asset

groups than is formal cred it (the g in i index for urban households

is 40 .2Z for informal c r e d i t and 55.1% for formal c r e d i t ) .

However, Lorenz curves cross when more than 3 asset groups are

used since a r e l a t i v e l y large share o f formal c red it goes to the

household asset group Rs 1 lakh to Rs 5 lakh. Thus, asset poor

and wealthy households receive r e l a t i v e l y more informal c red i t .

4.4.2 For samples o f p roduct ive units except f o r t ransport

operators, RBI data show, once again, that informal c red i t is more

equally distr ibuted ( in the Lorenz sense) when firms are class­

i f i e d by gross sales or earnings into 3 to 5 groups. Informal

cred it is s t i l l the main source o f finance for small industrial

and trading units.

4.5 Flow o f funds between formal and informal f inancia l sectors

4.5.1 While instances o f f low o f funds in both d irect ions be­

tween formal and informal sectors have come to l i gh t , the flow o f

funds from the informal to the formal f inancial sector is by far

the larger o f the two, even i f the fact that a l l intermediaries

and firms studied hold current accounts with banks is Ignored. Tne

three main instances o f th is , the case o f road construction, chit

1. The f i g u r e g i v e n in the t a b l e i s based on a sample o f bank a s s i s t e d u n i t s - I t is thus b ia s ed a g a in s t in f o r m a l c r e d i t .

fund8 and the Peerless case, between them result In at least Rs. 5

b illion flowing to the formal sector In recent years. In the case

of Nidhis about 11 per cent o f the ir assets are held as bank

balances.

4.6 Overall credit position of credit using sectors

4.6.1 While no spec i f ic information is ava i lab le about f i lm

finance, i t is c lear from our study that f i lm production would be

grea t ly a f fec ted in the absence o f informal finance.

a. Garment exporters, part icu lar ly the larger firms, are net rece ivers o f credit and are able to generate large inter­nal surpluses due to the combined ope ra t ion o f three factors: Cheap bank credit to finance exports, export tax concessions and the manner in which the quotas under the Multi Fibre Agreement are allocated between competing firms.

b. Road construction contractors are net providers o f credit to the monopsony buyer of their serv ices, the government, due to the need to provide security deposits and due to delayed receipts of dues.

c- Tex t i l e d istr ibut ion intermediaries in the middle o f thed i s t r i b u t i o n chain are net p rov iders o f c r e d i t , the benef ic iar ies being re ta i le rs .

d. Powerloom units reloan about half the ir borrowed fund as trade c r e d i t .

e. Bhole (1985) reports that large, and a f t e r 1970, small companies were net receivers of trade cred it basing this conclusion on data for 1956 to 1978. On average, firms in the RBI surveys are net receivers o f cred it , though for wholesale traders the net cred it receipts are mar­ginal .

4.6.2 This evidence, while attesting to the importance o f in­

formal credit and transmission o f credit received from se l le rs to

buyers also a t tests to the fact that some sectors are constrained

to own fund for capita l formation and working cap i ta l .

Inter- Trade Agri- Const- Trans- Indus- Consuap- Othermedlary culture ruction port try tlon

FinanceCorporation 35

Chit funds 45

10

8

9

Nil

4

Nil

6

Nil

12

37

24

10

HirePurchase

Nidhis

Shroffs

Nil Nil N il Bulk Minor

Housewives: 25 Z, Businessmen 25%, others 50 Z largely for house construction and repair

50 NA NA NA 10 Neg 40

Including self-employed.

S e c to r Own f und s

Formalc r e d i t

In fo rm a lc r e d i t

Road c o n s t r u c t i o n 62 6 32Garment e x p o r t s 31 26 43F i lm f in a n c e 5 N i l 95Powerloom u n i t s 43 10 47T e x t i l e Trade U n i t s 42 10 48Housing F inance o fHousehold s 66 20 14

RBI SURVEYS

HousehoIds N. A. 61 39Small S ca le I n d u s t r y 28 32 40Traders 28 19 53T ranspor t O p e ra to r s 49 41 10

Notes 1. 2 . 3 .

RBI surveys c o v e r o n ly u n i t s r e c e i v i n g bank a s s i s t a n c e NA = Not a p p l i c a b l eS h r o f f s do not in c lu d e M u l tan is who do r e c e i v e bank

r e f i n a n c e e s t im a t e d at about 5 - 1 0 per c en t o f t h e i r loans o u t s t a n d in g .

LOAN TERMS AND CREDIT APPRAISAL METHODS

5.1 Interest rates

5.1.1 Annual compound interest rates on advances are given in

Table 2.2. The rates are, in general, higher than bank rates as

are the deposit rates. One point o f interest is that interest

rates do not increase with the duration o f loans in a l l cases.

When short term loans have higher rates o f interest, this is in­

var iably because o f higher transactions cost or riskiness. In the

case o f dockyard financiers interest rates are unusually high

given the lack o f risk or transactions costs. The average interest

rates for productive sectors, in Table 5.1 below, are surpris ingly

low and are comparable to that o f banks (the State Bank of India

advance rate is currently 16.5 per cent ) . Trade credit rates vary

with the period o f credit since cash discounts were t yp ica l l y

spec i f ied . They tended to be somewhat higher than rates for d irect

loans given that the average period of trade credit was of f a i r l y

short duration.

5.2 Loan duration

5.2.1 The general isation that informal loans are short term is

incorrect. While i t is true that Shroffs and finance corporations

mainly have short term loans not exceeding ) months, chit funds,

Nidhis and hire purchase companies have loan durations measured in

years - upto seven years in the case o f Nidhis and before enact­

ment o f recent Chit Fund Acts, 10 years for chit funds. Trade

1. The huge r a t e o f 16,778% i s the a n n u a l i s ed i n t e r e s t on one day l o an s at 5% by f i n a n c e c o r p o r a t i o n s . However, i t should be noted tha t such loans a r e smal l and have h igh t r a n s a c ­t i o n s c o s t s to the l e n d e r .

credit periods o f upto 200 days were reported in wholesale trade

and the powerloom sector, though two months is approximately the

average. At the other end, finance corporations serve the very

short term end of the spectrum - starting from one day loans - a

segment not served by the formal sector.

5.3 Collateral

5.3.1 Nidhis, hire purchase firms, chit funds and auto finan­

c iers g ive secured loans. In the case o f vehic le finance, security

consists o f margin money and hypothecation o f the vehic le . The

margin may be as high as 50 per cent. Otherwise loans are mainly

unsecured, though loans against jewel lery are f a i r l y widespread.

However, long standing r e la t i o n s or borrowers being known to

lenders i s important espec ia l ly among Shroffs, finance corpora­

tions and in hire purchase. A recent trend, is the advertisement

o f loans a v a i l a b l e from informal lenders in nat iona l d a i l y

newspapers such as the 'Hindustan Times' and the 'Hindu'. This

suggests that, in some segments, long term relat ionships may be

losing importance.

5.4 Credit assessment

5.4.1 While Nidhis and hire purchase companies had an elaborate

but speedy cred it assessment procedure, most intermediaries re ly

on long standing personal contact with borrowers or their reputa­

tion in the 'market' . Thus, in most cases, the informali ty between

lenders and borrowers and speedy sanctioning of loans for which

informal markets are noted was maintained.

5.4.2 Clearly , no generalisat ions about loan terms in in for­

mal c r e d i t markets can be made. The s tereo typed ' loans from

moneylenders' are c lea r ly not representative o f Informal inter­

mediaries o f a l l kinds.

Using s e c t o r Range o f int ere st r a t e s

Average 1nforraal in te res t ra te

Average c a shd i scount on trade c r e d i t

1. Road cons t ruc t i on 15 - 24 15.89 -

2. Film f inance 67 - 99 - -

3. Powerloora 12 - 16 12.03 11 - 13

4. T e x t i l e who le sa le t rade 12 - 18 15.31 -

COST OF INTERMEDIATION

6.1 The decomposition o f interest rates

6.1.1 The main purpose o f th is chapter is to examine the

decomposition o f the lending rate o f informal in te rm ed ia r ies

following Bottomley (1975).^ The decomposition o f loan interest

rates is into four components: transactions cost, r isk premium,

opportunity cost and economic or monopoly rent. Essentia l ly , from

financial f igures o f the firm this can be deduced ex post. The

method we adopt i s the fo llowing. Per rupee o f funds loaned, pure

rent (R) can be represented by the identity

R = ( l - P ) ( l + r ) - T - Oe

where, P is the percentage o f loans defaulted, r is the average

interest rate charged to the borrower, T is the rat io o f total

expenditures to to ta l loans, 0 is one plus the opportunity cost

(o ) per rupee o f own funds and e is the rat io o f own funds to

total funds ava i lab le .

6.1.2 T can further be decomposed into E + I , where I is the

interest cost on borrowed funds per rupee o f loans and E is the

residual (establishment) cost per rupee o f loans. I can further be

written as ( l + i ) ( l - e ) , where, i is the average interest rate on

deposits and ( l~ e ) is the faction o f borrowed funds in to ta l funds

(under the accounting convention that borrowed funds are repaid,

though they may, o f course, be borrowed again immediately and lent

anew ) . Thus we get the re la t ion:

r - E + P ( l+ r ) + [ i ( l - e )+ o e ] + R (1 )

1. See a l s o Hanson and de Rezende Rocha ( 1 9 8 6 ) .

here, E Is the per un it estab l ishment cost ( o r t ransac t ions

cost )

p ( l+ r ) is the r isk premium (or , accurately, the cost o f

defaults )

[ i ( l - e ) + o e ] is the opportunity cost o f funds employed

(or the actual cost in the case o f borrowed funds)

and R i s the economic rent.

6.1.3 One adjustment needs to be made before the decomposition

can describe the s i tuation o f a r isk neutral lender (and we assume

r isk n e u t r a l i t y in t h i s s tu dy ) . There i s c l e a r l y a r e a l

opportunity cost to running out o f loanable funds, a s i tuat ion

which gives r ise to an increasing term structure o f interest rates

from the lenders viewpoint. Comparing the lender 's demand for

borrowed funds o f d i f f e r e n t m a tu r i t ie s to the market term2

structure, The deposit maturity which g ives the greatest surplus

to the firm w i l l be selected by Lt- I f Lt is in fact observed that

the lender borrows funds o f a l l maturities, then this suggests

Lndifference on the part o f the lender to a l l maturities or the

operation o f price or quantity controls (whether imposed by the

government or other private agents) on the borrowing market. In

the former event the h ighest in t e r e s t r a t e , ( j ) , should be

substituted for i and the d i f f e rence , ( j - i ) ( l - e ) should be added

to the risk premium, where the term L tse l f represents the cost o f

unava i lab i l i ty o f borrowed funds. In the la t t e r event i t is c lear

that the r isk premium should be augmented but there i s no easy way

o f esti iaating the required increment. In order to bias the results

towards high monopoly p ro f i t and because o f estimation problems,

we ignore such corrections and retain the formula ( 1 ) . In the

event o f r isk averse lenders or anticipated costs higher than ex­

post costs, (1 ) w i l l over estimate monopoly rent-

2. Under the a s s u m p t i o n o f p r i c e ta k L n g on th e m arke t borrowed funds .

f o r

6.1.4 The main Interest In such a decomposition is In order to

ascertain the extent o f monopoly rent and in order to compare

across Institutions. However the latter objective requires that

loans be taken Individually, or that lenders with identical loanO

por t fo l io be considered. The data for such an exercise is not

avai lab le . The problematic parts o f the decomposition are the

port ions concerning t ransact ions and d e fa u l t c o s t s . Deposit

costs, opportunity costs and economic rent are s t i l l comparable

across sectors. In general, transactions costs could be expected

to be higher for firms with predominantly short term loans and

when in d iv id u a l loans are small r e l a t i v e to the t o t a l loan

por t fo l io . However, data on the number o f loans are not avai lable

in a l l cases , and sample s izes are too small to attempt a

standardisation on th is basis. This caveat must be borne in mind

when analysing the estimates presented.

6.2 Estimates

6.2.1 Estimates were computed using average figures across a l l

firms, ignoring inter- f irm heterogeneity.^ In consequence the

figures r e f l e c t the average position o f firms. Our estimates are

given in Table 6.1 for 6 intermediary sectors. These estimates

assume an opportunity cost o f own funds o f 18 per cent for a l l

sectors except shroffs for whom an opportunity cost of 14 per

cent"* is assumed. The est imates show that there is reason to

suspect "monopoly power" only among auto-financiers in Namakkal.

However, the second hand auto-finance business is growing rapidly

and i t i s more l i k e l y that the rent estimate captures an element

o f disequilibrium pro f i t s . For shroffs , analysis for 1979 revealed

a rent element o f 35%. The decline in the use o f darshani hundis

I am i n d e b t e d to T .N . S r i n i v a s a n f o r p o i n t i n g out th e p r o b l e m s w i t h i n t e r m e d i a r y c o m p a r i s o n s based on a v e r a g e v a lue s .

When f l r r a w i s e d a t a w ere a v a i l a b l e . O t h e r w i s e o t h e r a p p ro x im a t i o n s a re used.

14% i s assumed on the b a s is o f d i s c u s s i o n s w ith re sponden ts in the f i e l d s u r v e y .

and the s a r a f l system as a whole due to the impact o f recent

repressive l e g i s la t i o n may explain th is , given that shroffs were

the s o l e su pp l i e r s o f t h i s instrument. The p o s i t i o n f o r the

inter-corporate funds market, fo r r isk adjusted Interest rates,

s im i la r ly appears to indicate lack o f monopoly pr ic ing, though

given the ' j o i n t producer' nature o f corporate lenders no estimate

were made. Thus the evidence does not support the hypothesis o f

monopolistic intermediaries in the sectors studied.

6.2.2 The high establishment costs reported in this table appear

to contradict the presumption o f informal lenders being e f f i c i e n t

purveyors o f c red i t . In fact commercial bank costs contributed

about 27 to 38 per cent o f the interest rate on loans (assumed at

16.5 per cent) in 1984 and 1985. Though the caveat in paragraph 3

should be kept in view and though i t should be kept in mind that

banks could probably not replace informal intermediaries In the

cred it submarkets served by them, these figures do tend to suggest

that a l l informal intermediaries are not e f f i c i e n t suppliers o f

c red it compared to banks in the sense o f having low transaction

costs. This f inding is at variance with e a r l i e r studies, such as

TImberg and A iyar (1980). They, however, do not attempt an

e x p l i c i t decomposit ion. From what is reported in the popular

press, and from the l i t t l e ev idence a v a i l a b l e , informal

intermediaries have substantially lower r isk costs than banks, a

f ind ing which is r e f l e c t e d in the Table. Before leav ing t h i s

chapter, we b r i e f l y summarise f indings on informal credit to using

sectors. Detai ls o f computations for banks are given in Tables 2

and 3.

6.3 Cost o f funds versus duration o f loaas o f c red i t using sectors

6.3.1 While most loans were found to be f o r working c a p i t a l

purposes and were thereby short term loans or even loans on c a l l ,

the mean e f f e c t i v e loan duration was greater than that for formal

sector c red i t in road construction. Furthermore, while the cost o f

Informal finance for f i lm making was between 67 per cent and 99

per cent per annum, the average in formal in t e r e s t rate was

estimated to be lower than the cost of bank finance in the other

sectors, though the median rate was .higher and the dispersion was

large in road construction. The main reason for this is that low,

often zero, interest rate loans from friends and relatives are

often used by firms. Furthermore, a regression, using Inter-State

data on the pooled samples from the RBI surveys of firms, of

interest cost on the ratio of formal to informal finance showed no

significant link between the two.

Fina l ly , persons interviewed in the text i l e wholesale

market reported that the effective cost of bank credit, inclusive

of their transactions costs, was higher than that of Informal cred it.

Estimated Decomposition o f Loan Interest Rates of Informal Intermediaries and Scheduled Commercial Banks

Sector Intermediaries (Figures In Z)

Default Establish- Oppor- Economic Averagecost ment cost tunity rent spread ( in

cost/ percentagecost o f points)borrowed funds

Financecorporations

4 25 68 3 103

Hire-purchase 3 33 66 -3 93

Nidhis Neg 19-20 78-79 1-3 5-7

Auto-financiers Ln Namakkal

7 26 26 45 19

Handloom financiers in Bangalore/ Karur

7/8 23/25 51/67 20/Neg 35/2

Shroffs o f Western India

14 20 60 16 8-9

Indian Scheduled Connercial Banks

( a ) No default assumption

- 33-38 54-67 0-7 6—1C

(b ) 2 % o f loans defaulted

16-18 27-34 48-54 Neg

Notes: 1. Opportunity cost assumed to be 18 % for own funds except forshroffs (14Z)

2. Neg: Neg l ig ib le .3. Dif ference in earnings per rupee o f loans and per rupee o f

deposits.4. Bank calculations are from Table 6.3.

Basic Data on Indian Scheduled Commercial Banks

(Rs lakh)

Item 1984 1985

Fron Annual Reports as on December Si

Paid up capital 18,381 65,070Reserves 87,007 118,958Deposits 8,468,447 10,028,467Profit (balance sheet) 637 991Total assets 11,119,422 13,120,176Investments 2,378,883 2,947,510Cash 1,314,775 1,593,727Money at c a ll 181,902 332,426Advances in India 4,583,593 5,225,024Advances outside India 761,000 796,493Due from banks (assets) 2,204 2,089Borrowing from banks ( l i a b i l i t ie s ) 733,259 810,595Interest and discount 815,683 944,056Total earnings 889,546 1,030,752Interest paid 585,826 682,629Total expense 883,622 1,024,680Profit (p&l) 5,924 6,072

Source: RBI, Statistical Tables relatlBanks In India, 1985.

Basic Data on Indian Scheduled Cooaercial Banks

(Rs lakh)

1985"Item 1984

From special returns to the RBI on Forms A1 & A2 (Total Business)

Paid up capital Reserves Deposits CashInvestments Money at c a l l Loans and advances B i l l business P ro f i t (balance sheet)

EARNINGSInland b i l l s Loans and advances Investment: government Investment: trustee Investment: other Deposits with RBI Deposits with banks Total oper. earnings Total earnings

EXPENDITURESInterest : deposits Intecest: borrowings Rediscounts Other business Establishment cost

OTHER EXC. FEES ETC.Taxes on operations Interest tax Total oper. expense Total expense Pre tax p ro f i t

30,66574,434

8,349,8201,315,1672,489,412

186,6594,733,334

610,9924,452

52,199.1547,067.5109,319.748.267.9 40,747.3 54, 759.311.159.9

949,279.2 970.979.1

513.563.255.590.6 10,393.110.210.7

204.173.2

1,468.113.458.8

872,896.0 891,248.279.330.9

65,020118,451

9,864,9171,595,2853,102,261

332,3995,411,078

611,2995,872

61,337.6660.127.6139.037.6 69,332.5

5,855.175.323.218.247.3

1,123,404.1 1, 145,832.'

607,641.9 64,210.1 13,199.6 11,576.4

235,938.5

1,655.04,016.8

1.014.407.41.053.390.5

92,441.6

Source: RBI, S ta t is t ica l Tables re la t ing to Banks in India, 1985.

Consolidated Data on Indian Scheduled Banks

(Rs lakh)

Item From annual reports From special returns

1984 1985 1984 1 985

Own funds 20,365 67,055 105,099 183,471Deposits 8,468,447 10,028,467 8,349,820 9,864,917Total funds 10,387,550 12,310,679 9,335,564 11,052,322Investments 2,378,883 2,947,510 2,489,412 3,102,261Advances 5,344,593 6,021,715 5,344,326 6,022,377Cash 4,765,495 5,557,450 1,501,826 1,927,684Interest and discount 815,683 944,056 599,267 721,465Total earnings 889,546 1,030,752 970,979 1,145,832Interest paid 585,826 682,629 523,956 620,842Establishment expense 297,796 342,051 367,292 432,549Pro f i t (balance sheet) 637 991 4,452 5,872Loans NA NA 547,068 660,128Bi l ls NA NA 52,199 61,338Return on investment NA NA 198,335 214,225Return on b i l l bus. NA NA 52,199 61,338

INTEREST RATES

Return on advances 17.66 13.50Return on loans NA 13.95Return on b i l l bus. NA 10.04Return on investment NA 6.91Deposit rate 8.06 7.44

RATIOS TO TOTAL FUNDS

1- Earnings 9.92 12.272. Deposit cost 6.57 6.653. Establishment 3.29 4.634- (2) + (3) 9.86 11.285. Opp. cost (18%) 0.03 0.176. Econ. rent 0.03 0.82

BREAK UP (NO DEFAULT)

I. Required return 9.92 12. 272. Deposit cost 66. 23 54.183. Establishment 33.18 3 7.754. Opp. cost 0.30 1.395. Econ. rent 0.29 6.67

(1) (2)

BREAK DP (1Z DEFAULT)

1. Required return2. Deposit cost3. Establishment4. Opp. cost5. Default cost6. Short fa l l

BREAK UP (2Z DEFAULT)

1. Required return2. Deposit cost3. Establishment4. Opp. cost5. Default cost6. Short fa ll

(3 ) (4 ) (5 )

10.99 12.5759.78 52.9129.95 36.860.27 1.36

10.00 8.879.74 2.39

12.09 13.6854.35 48.6027.23 33.860.25 1.25

18.18 16.2917.95 10.31

Note: For break ups with default ( 2 )+ (3 )+ (4 )+ (6 ) Source: As for Table 6.2.add up to 1002 i f the required return f a l l s short o f earnings l e s s economic rent plus default cost.

STRUCTURE OF INFORMAL CREDIT MARKETS

7.1 Introduction

7.1.1 In this chapter, we describe our findings on the structure

o f informal credit markets in terms o f various c r i t e r ia used in

industrial organisation theory. The evidence is reviewed in two

parts. F i r s t ly , we review the evidence on the market structure o f

intermediary submarkets for which f i e ld studies were conducted and

also o f the t raders-cum-in termediar ies in wholesale t rade .

Secondly, we address the issue o f fragmentation or integration in

informal credit markets as a whole.

7.2 Intermediary submarkets

7.2.1 In desc r ib ing market s t ructures o f intermediary

subsectors, ten c r i t e r i a are used. The f i r s t s ix are the standard

industrial organisation benchmarks o f numbers and concentration

(where the sample permits this to be studied), product var ie ty ,

p r ice/non-pr Ice compet i t ion , ease o f en try and e x i t , p r i c e

d i sp e rs ion , evidence o f market leadersh ip and ex istence o f

economic rents. The la t t e r is , o f course, judged by the monopoly

component o f Interest rates. In addition, informational aspects of

such markets are discussed since th is Is c ru c ia l to the

funct ion ing o f c r ed i t markets- In formational cons iderat ions

manifest themselves in add i t ion to p r i c e disperson and, on

occasion, entry barriers, In at least two ways. F irs t ly , lenders

can set maximum l im i t s on in te r e s t ra tes and ra t ion funds to

borrower rather than a l low ing the in te r e s t rate to c lear the

market ( S t i g l i t z and Weiss (1981)) . Secondly co l la te ra l is taken

or some other way o f securing loans Is In common use. Finally, the

e x is t en ce o f p r ic e or quant i ty c on t ro ls by the government Is

pointed out- Evidence for the intermediary submarkets is presented

in Table 7.1.

7.2.2 Before reviewing the evidence, the nature o f entry/exit

barr iers should be addressed. I t is c lear , a p r i o r i , that access

to loanable funds is a pre-requ is i te fo r becoming an informal

lender. Becoming an intermediary requires access, furthermore, to

depositors. These factors are c l e a r l y barr iers to most types o f

potentia l lenders with the possible exception o f chit funds among

fr iends and acquaintances. Since these barr iers are common to

almost a l l c r ed i t op era t ions , the tab le below ind ica tes the

e x i s t en c e o f en t ry b a r r i e r s on ly when evidence o f a d d i t i o n a l

d i f f i c u l t i e s Ln entering and leaving were found. Such barr iers

may, furthermore, be permanent or temporary. Temporary barr iers

ar ise from lack o f information about potentia l borrowers and other

in fo rmat iona l obs ta c le s . B a r r ie r s along caste and community

l ines , for example, are o f a more permanent nature.

7.2.3 The evidence sumrnartsed in Table 7.1 shows that with the

exception of aratiyas In the wholesale trade, dockyard financiers

and n idh is , in formal in t e rm ed ia r i e s are g e n e ra l l y at the

competitive end o f the spectrum. Informational imperfections, as

ev idenced by pc lce d i s p e r s i o n , r a t i o n in g and s e c u r i t y , are

s i g n i f i c a n t and the major cause o f i n e f f i c i e n c i e s . In h i r e -

purchase, there are dominant f i rms In the reg ions surveyed.

Aratiyas specia l ise by region which leads to short run Information

based entry barriers. For indigenous bankers, community based

entry ba r r ie r s and the need to e s ta b l i sh a reputat ion are

additional barriers.

7.3 Fragmentat Lon

7.J.1 The concept o f fragmentation f i r s t requires d e f in i t ion .

Two conditions can be said to be su f f i c ien t to determine whether

the informal c r e d i t market i s fragmented. F i r s t , fund f lows

between markets should be in su f f i c ien t to bring about equality o f

Interest rates across regions for similar loans and borrowers.

Secondly, th e re i s evidence o f fragmentat ion i f borrowers or

lenders are excluded from c r e d i t markets due to some

character is t ic unrelated to the ir a b i l i t y to lend funds or repay

loans. Note that i t i s possible for markets to be fragmented on

the deposit side (sources o f funds) and not on the loan side or

v i c e versa.

7.3.2 On the sources o f funds s id e , there appears to be

s ign i f ican t integration o f urban informal markets with many major

intermediary sectors in a region po ten t ia l ly having access to the

same pool o f depositors. Instances o f depositors from distant

regions have also come to l ight in hire-purchase.

7.3.3 On the lending side, the importance o f reputation and long

relat ionships argues for fragmentation within such submarkets.

Impressions gained from f i e l d surveys tend to suggest

f ragmentat ion according to both c r i t e r i a g iven above.

I n t e r r e g i o n a l and intergroup in te r e s t ra te d ispers ion can be

assessed by examining interstate RBI data from the A l l India Debt

and Investment Survey, 1981-82. Though interest rate data is not

avai lable , we use as a proxy the proportion o f household debt

bearing interest at the rate o f 20 per cent or more per annum.

While causes o f variat ion in this factor are c lea r ly influenced by

other f a c t o r s (such as the spread o f in formal in te rm ed ia r ies

i t s e l f ) , the var iat ion across groups o f borrowers and states is

examined s ince lack o f v a r i a t i o n would s t i l l be grounds fo r

re jec t ing the hypothesis. Necessary information is in Table 7.2.

From this i t can be seen that the data is consistent with the

hypothesis o f fragmentation both across states (the coe f f i c ien ts

o f var ia t ion ) and across groups (the corre la t ion c o e f f i c i en t s ) .

The most surprising finding is the high c o e f f i c i en t o f variation

among the urban se l f -employed t e s t i f y i n g to the extreme

hetrogeneity o f th is group.

7.4.1 Infom al markets have widely varying characteristics so

that the true economic efficiency of their functioning, re lative

to what Is possible given environmental limitations, is hard to

gauge on the basis of our limited study. S t i l l , it seems fa ir to

conclude that, with some exceptions, markets are at the

competitive end of the spectrum of market types. Evidence of both

integration and fragmentation has been reviewed. On balance one

would hypothesise that loan markets, but not deposit markets, are

s t i l l largely fragmented upto the 1980s.

Sector 4-firm concen­tration ra t io (%) (sample f irms)

Entry/exitbarriers

Localpricedisper­sion

Marketleader­ship

Economicrents

Number o f firms

Financecorporations 34.7 No Small No Small Large

Hire-purchase 87.7 No Yes Yes No Large

Nidhis NA Yes Yes No No 65

Chit funds 66.6 No No No NA Large

Auto-financiers NA No Yes No Yes (?) Large

Handloom financiers NA No No No No La rge

Aratiyas ( t e x t i l e trade)

NA Yes No No NA Fewserving a reg ion (Regional spec ia l - l sat Ion)

Wholesalers ( t e x t i l e trade)

NA No No No NA Large

Dockyard finaneiers NA Yes Yes No Large Small

Shroffs In NA(Hlgh) Yes No Yes No MediumWestern India

Sector Rationing Type of Security Government (P ) Price/in te rest (I ) Non and Deposit price (N ) (D) con- competition tro ls

Financecorporations

Hire-purchase

Nidhis

Chit funds

Auto-financiers

Flooramounts

NA

Duration/Amount

Amount

NA

Handloom NAfinanciers

Aratiyas NO( t e x t i l e trade)

Wholesalers NO( t e x t i l e trade)

Dockyard NAfinanciers

Shroffs in NoWestern India

Collateral

Marginal, reputation c o lla te ra l, guarantors

Collateral

Collateral

Margin,Guarantor,collatera l

DO

Reputation

Reputat Lon

ID

ID (Company NA Sector)od

ID

D

NO

Long Relationsilip No

Reputation Dlong relat ionship

None

N

N

None

N

Iater-State Variations in High Interest Loans to the Household Sector

A. Percentage of Loans with Interest Rate o f 20 per cent or More

Rural Urban

State Cult i ­vators

Non-culti­vators

S e l f - Non-Self- employed employed

Andhra Pradesh 38.4 52.7 22.0 36.82Assam 7.4 0.0 0.0 0.0Bihar 25.5 46.1 23.4 6.3Gujarat 7.2 3.7 0.0 0.6Haryana 13.7 47.1 42.4 1.8Himachal Pradesh 1.9 0.0 0.0 0.0Jammu & Kashmir 2.8 0.0 0.0 0.0Karnataka 6.1 9.9 8.0 8.7Kerala 8.4 33.3 56.4 3.0Madhya Pradesh 27.9 23.3 8.0 14.7Maharashtra 4.6 5.3 6.8 3.5Orissa 10.4 38.0 2.6 1.8Punjab 12.3 16.1 5.5 14.8Rajasthan 33.8 41.6 8.0 18.3Tamil Nadu 30.1 33.5 15.0 26.8Uttar Pradesh 28.7 47.8 22.9 15.0West Bengal 14.9 7.4 26.7 17.6

Coef f ic ien t o fvar iation 0.7391 0.8194 1.1038 1.0704

B. Estimated Correlat ion Matrix o f Variables

Sector Cult i­ Non-culti­ S e l f - Non- s e l f -vators vators employed employed

Cult ivators 1.0000 0.7595 0.2209 0.8295Non-cultivators 0.7595 1.0000 0.5597 0.4863Self-employed 0.2209 0.5597 1.0000 0.1414Non-self-employed 0.8295 0.4863 0.1414 1.0000

Source o f data: RBI, A l l - Ind ia Debt 'arid "investment Survey,”1981-82."

SIZE AMD TRENDS Dl SIZE

8.1 Preliminaries

8.1.1 Given the qual i ty o f data ava i lab le , i t is a moot point as

to whether th is chapter should have been written at a l l . However,

no r e l i a b l e es t imates o f the s i z e o f the in formal s e c to r are

avai lable and so even rough estimates such as are presented here

are o f some value. The estimates must, however, be found wanting

by any absolute q u a l i t y standard. This being the case no

s t a t i s t i c a l confidence in terva ls fo r the data presented here are

reported even when these were computed and found to be acceptable.

Of the various estimates given, great confidence can be placed in

the 'es t imates ' for Nidhis alone. This is because these are not

es t imates but popu lat ion f i g u r e s . No other est imate can be

considered r e l iab le in any absolute sense.

8.2 Methodological issues

8.2.1 Magnitudes reported: How is size to be measured? Our main

focus in computing these es t imates is to assess two f a c t o r s .

F i r s t , to the extent that the size o f informal markets r e la t i v e to

the formal sector r e f l e c t s on the a b i l i t y o f the central bank to

control c red i t , monetary aggregates rather than numbers o f c l i en ts

or transactions intermediated are c lea r ly appropriate. Secondly,

given that our evidence shows that informal credit forms the more

important source o f funds for poor households and small firms,

f inancial aggregates w i l l g ive a lower bound (rather than numbers

o f customers or accounts) on the Importance o f informal finance to

particular sectors r e l a t i v e to formal c red it . Thus, our estimates

are for f inancial aggregates only since i t is these two factors

which are o f interest to us and, we be l ieve , general ly . In l ine

with these ob jec t ives , for f inancia l Intermediaries the amount o f

funds Intermediated Is of Interest. Thus, figures on both deposits

and advances by them are o f interest. Similarly total Informal

credit to a l l sectors Is o f Interest and is accordingly estimated.

8.2.2 Measurement o f magnitudes: A second Issue Is In thei actual

measurement o f c red i t or deposits. The Reserve Bank report^both

stock figures to capture s ize and changes in stocks to capture

trends in s i z e . A p r i o r i , however, s tock f i g u r e s are

inappropriate. To see this note that two intermediaries, both

with the same stock o f loans outstanding on a given date may have

very d i f f e r en t Impacts i f one g ives out one day loans ( to take an

extreme example) and lends ava i lab le funds exact ly once a year,

while the other is f u l l y loaned up throughout the year. Some way

o f in co rpo ra t ing the time dimension f o r d i f f e r e n t loans and

deposits must be found to overcome th is problem. One way Is to

add the stock o f deposits/loans outstanding over each point in

time (or day) over the entire year or the ent ire period for which

a credit/deposit measure is sought.^ This is then a flow estimate

having the dimension 'rupee-days per year' (o r rupee-years per

year with appropriate normalisation). When stock f igures are

available only at widely separated points o f time, then o f course

a trend curve can be f i t t e d to estimate stocks at intermediate

dates. For example, i f a constant rate o f increase o f the stock

between two points T1 and T2 Is found, then for the interval (T l ,

T2) the appropriate measure is T l plus l ia lf the di f ference between

T2 and Tl or, that i s , their simple average.

8.2.3 Thus for most f inancial Inst i tut ions, who may be assumed

to have a constant l e v e l o f outstandings throughout the year, or a

r epe t i t i v e pattern o f f luctuations in each year, the stock figures

1. Even t h i s I s open to o b j e c t i o n s . A more a p p r o p r i a t e measure w ou ld , f o r e x a m p le , w e i g h t l o a n s o f d i f f e r e n t d u r a t i o n d i f f e r e n t l y . Other c o n s i d e r a t i o n s may a l s o be brought to bear .

2. The id ea o f t h i s paragraph a r o s e as a r e s u i l t o f d i s c u s s i o n w i th CPS Nayar and S r i n i v a s a Madhur r e g a r d i n g th e measuretaent o f d e p o s i t s w i th c h i t funds .

themselves are reasonable proxies. However i f the pattern o f

f luctuations d i f f e r s fo r two d i f f e ren t f inancia l Inst i tut ions, a

comparison o f stock f igu re w i l l be misleading. One ins t i tu t ion

for which stock f igures are c lea r ly misleading for the purpose o f

comparison are ROSCAs (such as chit funds). This i s because o f

the very^a tu re o f th e i r ' l o a n ' and 'd e p o s i t ' transactions. Thus,/

in their case, f low estimates are needed.

8.2.4 Given data l im ita t ions our estimates are (except in the

case o f chit funds and one or two others) stock estimates as a

proxy fo r rupee-year per year f igures. Also, fo r bank deposits we

use la test year stock f igures in order to retain consistency with

Informal sector estimates and to ' l o a d ' the results in favour o f

the formal sec to r (whose aggregate depos i ts and advances

outstanding have grown consistent ly in Ind ia ) .

8.2.5 The conceptual problem as to the relevant credit magnitude*1

to be used is problematic even with the correct choice of units.

Consider this example: Two firms A and B each borrow Re 1 from a

bank. While A uses the borrowed funds to buy productive inputs

from B, B redeposits the money in the bank Intending to put i t to

use la ter . At the s tar t o f the next period, the bank ca l l s in i t s

loan from A but not B. B allows A to pay for purchases la te r and

makes use o f I t s bank loan to meet i t s payments. In both

s i tu a t ion s ( p e r i o d s ) , p roduc t iv e a c t i v i t y Is the same. This

example suggests that d i f f e r en t l e ve ls o f cred it may finance the

same leve l of productive a c t i v i t y depending on the volume o f id le

balances - in both cases the volume o f p roduc t iv e ly employed

credit Is Re I (times the period length). I f firms do indeed hold

id le balances as a precaution against anticipated or unanticipated

monetary stringency, then the "correct" measure o f credit as a

productive input would have to be net o f such id le balances. In

fac t , even i f there were transient id le balances, these would have

to be deducted. L ik ew ise , as the second part o f the example

3. T h i s p a r a g r a p h was m o t i v a t e d by h e l p f u l d i s c u s s i o n w i t h S r i n i v a s a Madhur, who h o w eve r , does not n e c e s s a r i l y share the v i e w e x p r e s s e d .

shows, c r e d i t which i s on - len t ( sub- intermedia ted ) should be

counted only once.

8.2.6 Such corrections are Important part icu lar ly vrtien trying to

gauge the importance o f two a lternat ive cred it sources l ike formal

and in fom a l c red i t . However, the example is simplistic and does

not discuss any benefits which may arise from the ab i l i t y to hold

id le balances and the a b i l i t y to on-lend (the la t t e r is , o f course

related to the question o f fu n g ib i l i t y o f credit from d i f fe ren t

sources).

8.2.7 An a d d i t i o n a l issue ra ised by the second part o f the

example is attr ibution. Is the rupee o f bank cred it to B which is

on-lent to A fo m a l or in fomal credit? Again the answer is not

c lea r s ince the loan i s g iven by a formal i n s t i t u t i o n and

sub intermedia ted by an in fom a l agency. In pract ice, th is raises

the issue o f the correct method o f treating bank refinance o f

In formal lenders and agents such as who lesa lers who have

s ign i f icant on-lending.

8.2.8 Unfortunately, methods for correc t ly measuring credit have

yet to be developed, to our knowledge. Thus, while recognising

the l im ita t ions in the procedure, we st ick conceptually to the

simple minded method o f adding up the (t ime In teg ra ls o f )

formal/informal l i a b i l i t i e s from balance sheets o f firms for our

user based estimates in Table 8.1. Estimates for intermediaries

in Table 8.2 are less a f fected given neg l ig ib le inter-intermediary

funds f lows . We may mention that even though by th is method

credit in both parts o f the example amounts to Rs 2, in general,

i t i s not true that there is a one to one correspondence between

'productive c r e d i t ' and our credit measure. However, what Is true

Is that apportionment o f c r e d i t into formal and Informal

components, Re 1 each in the second part o f the example , remains

straightforward.

8.2.9 Types o f estimates: Three sets o f estimates are reported.

An estimate of aggregate informal credit broken down by broad

credit receiving sectors, estimates o f aggregate deposits and

advances o f informal intermediaries and estimates o f Informal

credit going to selected sectors.

8.2.10 In making these estimates the basic approach was to use

sample estimates o f the rat io o f informal c red i t to some magnitude

for which aggregate information is ava i lab le (such as bank credit

or value added). Informal c red i t is then estimated as the sample

rat io times the aggregate f igure . When i t was possible to use

more than one magnitude, th is was done. In such cases a l l

estimates are reported. In some cases the resulting aggregate

est imate was fu r ther blown up to a r r i v e at an estimate for a

broader grouping o f sectors using value added figures ( . e . g road

construction is a narrow grouping with construction as the broader

grouping). Dates for estimates given r e f e r to the date for which

aggregate f igures were avai lable . Thus, imp l ic i t ly , we assume

that the sample ra t io is unchanged between the sampling period and

the date o f the estimate. Also, the procedure c lear ly assumes a

un i ta ry e l a s t i c i t y o f in formal c r e d i t with respect to the

aggregate magnitude used. For one large subset o f estimates used

to compile estimates o f Informal cred it by receiving sectors the

assumption o f unitary e l a s t i c i t y was s t a t i s t i c a l l y tested and not

re jected with high confidence. Details o f aggregates are in Table

8.1. Sources o f data for estimates are l i s t e d in the Appendix.

8.2.11 In compiling the estimates o f aggregate informal credit to

using sectors, we have de l ib e ra te ly chosen to bias the estimates

against Informal credit so as to get a lower bound rather than an

upper bound est imate for in formal c r e d i t . Deta i ls o f b ias

de l ib e ra te ly introduced are as fo llows:

a. Ratios o f informal c red i t to formal cred it and o f Informal c red i t to value added were based on Reserve Bank o f India

Va lue o f p r o d u c t i o n in the case o f sm a l l s c a l e in d u s t r y and a w e ig h t e d a v e r a g e o f c r e d i t pe r v e h i c l e o f d i f f e r e n t t y p e s f o r t r a n s p o r t o p e r a t i o n s .

surveys o f Small Scale Industr ies, Traders and Transport Operators. These surveys were biased against in fomal s e c to rs as on ly u n i t s r e c e i v in g formal c r e d i t were Included in the survey.

b. Even though a s t a t i s t i c a l t e s t f a i l e d to r e j e c t the hypothesis o f a unitary e l a s t i c i t y o f in fomal credit per firm with respect to income, using cross sectional data and state domestic product as the income variable , the preferred estimate uses an average o f two estimates, one using bank credit ( the low estimate except for transport operators) and the other using value added.

c. Though the test reported is fo r in fomal credit per firm yet no attempt was made to co r rec t fo r growth in the number o f firms.

d. Only selected sectors were used in compiling aggregate est imates whereas the bank c r ed i t f igure used for comparison is for a l l (urban and rural) sectors.

e. When aggregate estimates were not avai lable for the most recent year (1986-87) no attempt was made to project these f igures. In contrast, the bank cred it f igure is the most recent avai lable .

f . A large portion o f informal credit was subtracted from the gross t o ta l obtained as poss ib ly cons is t ing o f black money.

One source o f double counting, between private limited companies

and other sectors, could not be eliminated. However, the overlap

between such companies and f igures for other sectors Is less than

one per cent. In fact the bias does not exceed Rs 250 crore and

should in fact be much lower.

8.2.12 In compiling other estimates, while caution was used, no

del iberate bias was introduced.

8.3 Estimates o f size

8.3.1 The estimates o f informal credit to receiving sectors Is

given in Table 8.1. As can be seen, despite the anti Informal

cred it bias, our estimate shows that informal credit is 73.2 per

cent o f gross bank c r e d i t . The sec tor absorbing the g rea te s t

5. See the p r e v i o u s f o o t n o t e .

8.3.2 Estimates o f cred it and deposits o f intermediaries are

g iven in Table 8.2. As can be seen, f in a n c ia l a c t i v i t y by

intermediaries is unimportant r e la t i v e to bank cred i t . Only 18 per

cent of advances and 11 per cent o f deposits are with informal

intermediaries. Madhur (1987) estimated informal deposits for a

d i f f e ren t subset o f firms at 16 per cent. The bulk of the 'o th e rs '

f igure consists o f trade c red i t . Trade cred i t is therefore seen to

be the most important component o f in formal c red i t . * * Among

in te rm ed ia r ie s , the dominance o f c h i t funds (by the middle

estimate) , f inance corporations and hire purchase may be noted.

Also o f note is the large size o f the unclassif ied firm, Peerless

General Finance and Investment Limited.

8.3.3 Informal credit estimates for spec i f ic sectors from f i e ld

surveys which are included but not reported separately in Table

8.1 are in TibLe 3-3. As mentioned, the basis o f computations is

in the Appendix. A problem with the in t e r - c o rp o ra te funds

estimate is that i t cannot be reconciled with the estimate o f

informal c red it to public l imited companies in Table 8.1. Though

the two es t imates are based on d i f f e r e n t aggrega te f irm

populat ions , there is a la rge ove r lap . This suggests that

co rpora te r e l i a n c e on informal c r e d i t is much higher than is

reported in Table 8.1 or that our estimate o f inter-corporate

funds is seriously biased.^ The l a t t e r may be ruled out since

even the to ta l intercorporate cred i t in the sample exceeds the

relevant RBI f igure . No attempt was made to adjust the Table 8.1

f igure upwards in keeping with our general approach.

6. Thought t h e r e i s no s e p a r a t e c h a p t e r on t r a d e c r e d i t , i t hasbeen s tu d i e d in the c o n t e x t o f a l l c r e d i t u s in g s e c t o r s . See a l s o Bhole ( 1 9 8 5 ) , whose r e s u l t s a r e summarised in ch a p te r 13 .

7. In f a c t Bho le (1 9 8 5 ) f i n d s t h a t t r a d e c r e d i t a l o n e i s asim por tan t as bank c r e d i t f o r th e sample o f f i r m s he s tu d i e dand the y e a r s to which h i s da ta p e r t a i n .

8.4.1 Since our data i s l a r g e l y c ross s e c t i on a l , l im i t ed

evidence on the growth o f informal c red i t is available. Thus,

while the impression has been gained o f a rapidly growing in fomal

sector, we have only l imited d irect evidence. For intermediaries,

the p o s i t i o n i s much b e t t e r due to the a v a i l a b i l i t y o f RBI gestimates. The following trends emerge from here:

i . H ire Purchase : Growth o f d epos i t s f a s t e r than bankdeposits.

i i . Finance Corporations: Declining (See Appendix 2 of thechapter on Finance Corporations).

i l l . Chit Funds: Growth o f credit/deposits faster than banks.Growth in popularity outside South India, i t s tradit ional stronghold.

iv . N idh is : Growth f a s t e r than bank c r e d i t ( f rom a small base).

v. Indigenous Bankers (Based on estimates provided by theBombay Shroffs Associat ion): Declining sharply.

Relevant f igures for the f i r s t four categor ies are to be found In

the respective chapters o f the report.

S u r v e y o f d e p o s i t s w i t h N o n -B a n k in g Companies c o n d u c t e d a n n u a l l y . These s u r v e y s e x c lu d e non company I n t e r m e d i a r i e s .

Aggregate Estimates o f Urban la formal Credit la India by Sector o f Use

(Rs Crore)

Sector Year Estimate

Low Middle High

1. Pr ivate construction o f 84-85 which Housing (Pr ivate 84-85 res ident ia l build ings)

2. Small scale industry Low:Jan,85High:86-87

Mid:Ave3. Road construction 86-874. Road transport, related 84-85

services and storageo f which road Low:86-87transport High:Jan,85

Mid: Ave5. Trade, hotels & restaurant 84-85

o f which trade Low:Jan,85High:84-85

Mid: Ave6. Recreation, entertain- 85-85

raent & personal serv ices7. Public l imited companies 84-858. Private l imited companies 85-869. Urban household informal 81-82

debt9. Total Infoxual cred it

o f which estimated black money used in businesses

10. Net to ta l11. Gross bank c red i t (P ) March 8712. Ratio o f (10) to (9 ) (%)13. Ratio o f (9 ) to (11) (%)14. Ratio o f (10) to (11) (Z )

5840

1040

36759

865559

8953

4541391

1232

5447251673

12066

1423

66586

1184

1187112141193

3159735849

45748 62 543

56.07130.6373.15

Notes: 1 .2 .

P: ProvisionalYears/dates given are fo r aggregate f igures used to in f la te sample estimates. Stock cred i t f igures may be taken to prevail at the mid point o f periods In cases where flow aggregate f igures were used.For the basts o f estimates see the Appendix.

Aggregate Estimates of Credit and Deposits Activity o f Informal Intermediaries

(Rs. crore)

SectorTyear Advances Deposits

Low Middle High Low Middle High

1. Hire purchase 1555(March1987)

3759(June1987)

2827(March1987)

2. Finance corporations (December 1986)

692 692

3. Chit funds 2394 (March 1986)

8163 8260 2394 8163 8260

4. Nidhis (March 1986) 70 74

5. Peerless General Finance and Investment Company (December 1987)

26 612

6. Indigeneous Bankers 1084 361

7. Subtotal for major interned ia r ies

13794 12729

8. Trade cred it , friends & re la t ives and other informal Intermediaries

31954

9. Total 45748

10. Gross bank credit/deposits 62543 108411

11. Ratio o f (6 ) to (9 ) (%) 22.06 11.74

Note: See Appendix for basis o f estimates.

Sectoral Estimates o f Informal Credit Based on Field Data

(Rs. Crores)

Sector Date/year Informalo f estimate credit

Garment exporting units 86-87 259

Powerloora units 86-87 914

Film production 279

Intercorporate funds markets March 86

Public sector 3392

Private sector 600

The Basis of Aggregate Estiaates.

1. Housing (p r iv a te re s id en t ia l con struction ):Rat io o f total cost o f new housing stock o f homeowners to housing f inance from ex te rna l ( in f o r m a l ) sources in V .D .La l l (1984), 'Housing Finance In India ' NIPFP, New Delhi, and gross fixed capital fonaation in housing, National Accounts S ta t is t ics , 1987.

2. P r iv a t e Construct ion : Propor t ionate increase byrelevant aggregate s t a t i s t i c using (1 ) .

3. Snail Scale Industry: Low estimate: Proportion o f non- inst i tut ional c red i t to formal credit in RBI, Survey o f Small Scale Industr ial Units, 1977, and Scheduled Commercial Banks advances to small scale industry from RBI, Report on Currency and Finance, 1986-87.

High estimate: Ratio o f noninstl tut ional credit to value o f production and value o f production o f small scale industry in the same sources respect ive ly as for low estimate.

4. Road Construct ion : Informal credit is estimated using Gross Capital Formation in Roads and Bridges in the Public Sector from National Accounts S ta t is t ics and sample ra t io of informal c red it to value o f production.

5. Road Transport : Low estimate: As for high estimate for small sca le industry , using RBI Survey o f Traders and Transport Operators, 1978-79 and number o f vehic les ( o f d i f fe ren t types) in 1984-85 from Basic s t a t i s t i c s relating to the Indian Economy,1986.

High estimate: As for low estimate o f smallscale industry using the same source o f aggregate data and using the RBI Survey o f Traders and Transport Operators for the informal to formal cred it ra t io .

6. Road transport, re lated serv ices and storage:As for (2 ) , usLng the middle est imate o f (5 ) and value added proportions.

7. Trade: Both low and high estimates as in ( 3 ) , but using RBI survey o f Traders and Transport Operators,1978-79 for survey data and gross value added for the high estimate. Aggregate gross value added was taken from National Accounts S ta t is t ic s , 1987.

8. Trade, Hotels and Restaurants: As in ( 2 ) , using (6 ) and value added on the middle estimate.

9. R ec rea t ion , En ter ta inaen t and' Persona l S e rv ices :Residual Estimate using value added with and without this

sector from the National Accounts S ta t is t ic s , 1987.

10. Public and Private Limited companies: Sample figures from 'Finances o f Public Limited Companies 1982-93 to 1984-85', RBI Bullet in, May,1987 and 'Finances o f Private Limited Companies', RBI Bullet in, September, 1986, using residual category o f borrowed funds ( Item I 4 ( i i i ) ) and Trade Dues and Other L ia b i l i t i e s (Item G).

11: Urban Household Informal Debt: RBI A l l India Debt and Investment Survey, 1981-82, and household population figures from Census o f India, 1981.

12. Black Funds Bmployed: Average proportion o f cred it from friends, re la t ives , d i rec to rs , partners and shareholders for combined samples o f who lesa le t rade , powerloom u n i ts , garment exporters and road construction contractors applied to estimate o f to ta l informal cred it in Table 8.1.

13. Hire Purchase: Low estimate: Federation o f Indian Hire Purchase Associations for 1982-83 and estimated growth rate o f stock on hire in sample.

High e s t im a te : Number o f h i r e purchasecompanies from Nayar (1984) and growth ra te o f average deposits per company from RBI Survey o f Deposits with Non­banking Companies for the years 1982-87.

14. Finance Corporations: Based on Nayar (1984) for numbers and RBI Survey of Deposits with Non-banking Companies for deposit growth using the fact that deposits were almost equal to advances for sampled firms.

15. C h i t Funds: Low es t im a te : based on averagedepos it s/advances per company in rupee years per yearmultiplied by number o f companies in RBI Survey o f Deposits with Non-banking companies, 1986.

Middle estimate: average across sample firms o f twelve times the monthly subscription, multiplied by number o f firms from the RBI as In low estimate.

High estimate: Ratio o f deposits In rupee yearsper year to monthly subscriptions per sample firm multipliedby RBI f igures o f deposits with chit companies.

16. N idh is : RBI f igures from Survey o f Deposits with Non­banking Companies, 1986 fo r d epos i ts . Deposit f i gu re m u l t ip l i e d by sample r a t i o o f advances to depos i ts fo r advances.

17. Indigenous Bankers: 25 per cent o f the est imate In Timberg and Aiyar (1980), since the Bombay Shroffs estimate that business has declined by th is percentage o f the 1980 leve l .

18. T rade C r e d i t , e t c . : Residual est imate using t o t a l Informal credit estimate from Table 8.1.

REGULATION OP INFORMAL INTERMEDIARIES

9.1 The current regulatory enviroment

9.1.1 Regulations governing informal intermediaries have been

b r i e f l y alluded to in Chapter 6 and described in more de ta i l in

the case studies.

9.1.2 Currently, the following major laws or direct Lons in force

govern the workings o f non bank intermediaries aside from special

acts governing ch i t funds and h i r e purchase the l a t t e r being

In e f f e c t i v e ly enforced i f at a l l .

L. The Non-Banking F inanc ia l Companies (Reserve Bank) D irec t ions , 1977 (as amended upto 1984). (abbrev ia ted NBFD)

i i . The Miscellaneous Non-Banking Companies (Reserve Bank) Directions, 1977 (as amended upto 1984). (MNDB)

i l i . The Residuary Non-Banking Companies (Reserve Bank) Directions, 1987. (RNBD)

iv. Chapter I11B o f the Reserve Bank o f India Act, 1934 (which came into force in 1963).

v. Chapter II1C o f the Reserve Bank o f India Act, 1934 (which came into force in 1983).

v l . Chapter V o f the RBI Act, 1914.

9.1.3 In a dd i t ion i n e f f e c t i v e l y en forced money lenders acts

impose interest rate ce i l in gs in various states in India.

9.1.4 Chapter V re la tes to penalt ies for v io la t ion o f a various

Provisions and Directions la id down by the RBI.

9.1.5 Chapter TUB ap p l i e s to a l l incorpora ted non-banking

depos it taking in s t i tu t i o n s and other non-bank f in a n c ia l

inst i tut ions . The chapter defines the powers o f the Reserve Bank

over these inst i tut ions with respect to :

i . Issuing advertisements and other promotional material

i i . Information i t Is empowered to c a l l for

i i i . Directions Lt may Lssue

iv . Inspection and

v. So l i c i t in g of deposits by such ins t i tu t ions .

9.1.6 Chapter I I IC appears to be an attempt to plug the loophole

with respect to unincorporated bodies which came to l igh t in the

Sanchaita case and in other s imilar cases. The main provision o f

thLs sec t ion l im i t s the number o f depos i to rs which an

unincorporated body can accept to 25 per partner (o r Individual in

case o f an unincorporated association o f individuals) and 250

overa l l . Certain powers o f search, In case i t is suspected that

the nuraber o f depositors exceeds th is l im i t , are also laid down

under this section, the Reserve Bank recent ly took action against

f l y by night 'blade companies' in the states of Karnataka and

Kerala which had sprung up Ln recent years. Tnese firms are dealt

with Ln greater de ta i l elsewhere in the report.

9.1.7 The three sets o f Directions apply to d i f f e ren t groups o f

Informal Lntermed iar ies• A l l o f them however apply only to

companies as defined in section 451(a) o f the RBI Act, 1934 and

not to other unincorporated firms. A l l three sets o f d irect ions

pl ace l im i t a t i o n s on the dura t ion f o r which depos i ts can be

accepted. In addition both Direct ions o f the year 1977 lay down

ce i l in gs on the ratLo o f net owned funds to deposits. Deposit

interest rate ce i l in gs applicable to most firms are la id down in

NBFD and MNBD and a cash "reserve r a t i o ” for certa in firms in also

la id down in NBFD. As discussed e a r l i e r RNBD, which applies to

Peerless, lays down stringent requirements for the loan po r t fo l io

allowed.

9.1.8 As can be seen from the b r i e f description given above, a l l

three sets o f Directions as also Chapter I I IC are In the nature o f

quantitative res tr ic t ions on the extent o f deposit taking business

of an intermediary. Furthermore, deposit interest rate c e i l in gs

and res tr ic t ions on loan po r t fo l io s are also laid down.

9.1.9 The Chit Fund Act, 1982 lays down certain provisions to

ensure that subscribers interests are protected but also provides

c e i l in gs on the duration o f ch its and the maximum bid in auction

ch its , the la t t e r amounting to an interest rate c e i l in g . These

ce i l in gs , i t is argued in the case study, are undesirable.

9.1.10 A Hire Purchase Act Ls also on the statute books though I t

is yet unenforced.

9.1.11 F in a l l y , a llundi Code B i l l , d ra f t ed by the Rajamannar

Committee (1978) In consultation with various business and shroffs

organisations and which Is seen by businessmen to be progressive,

has yet to be tabled In Parliament.

9.1.12 In the l igh t o f our discussion currently in the previous

paragraphs I t Ls easy to see that, i f enforced properly, the major

laws governing informal cred it Intermediaries w i l l s t i f l e the

healthy development o f Informal f inanc ia l markets. Directions for

Information returns and for advertisements and also the powers o f

the RBI under Chapter I I IB appear, however, to be adequate for the

formulation o f suLtable monitoring schemes. Also, as the case

studies show, the current corpus o f regulations does not In any

way prevent questionable firms from winning the approval o f the

RBI or from Indulging in counterproductive a c t i v i t i e s . I t should

be c lear , without further discussion, that a drastic overhaul of

the regulatory corpus and also i t s enforcement machinery is called

for .

9.2.1 Many sh ro f f s ' organisations and associations o f traders

have elaborate se l f - regu la t ion and arb itra t ion committees. In

Calcutta , a t rade rs a s s o c ia t i o n even has a tw o - l e v e l appeals

structure . Due to the im p l i c i t threat o f ostrac ism these

organisations are reported to be remarkably e f fe c tLve . They are

also much faster and cheaper than the courts (See also Timberg and

ALyar (1930)).

9.3 Government regulation at work:

9.3.1 Four cases o f government regulation are discussed in the

report. The f i r s t case study documents the progressive s t i f l i n g

o f shroffs o f Western India by regulations such as Chapter I I IC

and requirements under the Income Tax Act that payments above a

certain size by made by cheques rather than, say, hundis. The

second case study concerns the government's attempts to regulate

the intermediary firm Sanchalta Investments. Due to a weakly

aade out case the Supreme Court quashed lega l proceedings against

Sanchaita, even whi le acknowledging that i t paid In te r e s t on

depos its out o f fresh depos i ts and had a quest ionab le loan

por t fo l io . The third case, that against the 50 years old Peerless

General Finance and Investment Company was also thrown out o f the

coucts since the Reserve Bank tr ied to c la s s i f y the firm as a

banned ' p c l z e d chlt/money c i r c u l a t i o n scheme'. This

c lass i f i ca t ion Is d i f f i c u l t to accept. In fact , though Peerless '

a c t i v i t i e s were in some cases arguably sharp, i t was by and large

an innovative and dynamic f inancia l intermediary. Thus the wisdom

o f attempts by the Reserve Bank to suppress Lt completely can be

questioned. The fourth case re la tes to the RBI's action against

finance corporations known as 'b lade companies' in Kerala. These

companies had expanded grea t ly in the wake o f the sharp increase

in remittances from Indian workers in the Persian Gulf. Many more

c l e a r l y unsound and ' f l y - b y - n i g h t ' f i rms took advantage o f

g u l l ib l e depositors and secured borrowers a l ike . While the RBI

succeeded in ident i fy ing and bringing action against a number o f

unsavoury firms, the ir action caused runs by depositors on a large

number o f f inance co rpo ra t ions . In the process , severa l

corporations, which were not f ly-by-n ighters , fa i l ed due to runs

on them by depositors- I t i s not c lear , that the RBI's action in

this case was misguided, but the fact remains i t that did have

pa r t ia l l y negative consequences.

PART C

ANALYSIS OF ECONOMIC IMPACT OF INFORMAL CREDIT MARKETS

INFORMAL CREDIT AND THE EFFICIENCY OF RESOURCE ALLOCATION

Concepts o f efficiency for financial markets

10.1.1 In analysing the e f f i c i e n c y o f resource a l locat ion , the

ultimate focus must be on the nonwastefulness o f factor use and on

the a l l o c a t i o n o f f a c t o r s to the most s o c i a l l y product ive

purposes. To analyse the impact o f credit on the e f f i c i en cy o f

resource a l loca t ion , a framework i s required that re lates credit

a va i l a b i l i t y and the cost o f c red it to these.

10.1.2 Tobin (1984, quoted in Fry, 1988) lays down four

concepts for judging the e f f i c i en cy o f a f inancial system:

a. Information arbitrage efficiency: which is the degree o f gain poss ib le by the use o f commonly a v a i la b le information. E f f ic iency is inversely related to the gain.

b. Fundamental valuation efficiency: The extent to whichthe present discounted benef its stream from an assetare re f lec ted in I t s price.

c. F u ll insurance e ff ic ie n c y : The ex ten t o f hedging possible against future contingencies.

d. Functional e ff ic ie n c y : This i s r e f l e c t e d in thetransact ions cost o f borrowers and lenders combined (lower transactions costs re f le c t more functionally e f f i c i e n t the market). An extended discussion of this concept is In Fry (L988).

10.1.3 Im p l ic i t l y , these concepts re f le c t the Irapact o f credit

markets on the e f f i c i en cy o f resource al location. However, while

information arbitrage e f f i c i en cy and functional e f f i c i en cy are

c e r t a in l y concepts which can be used in judging the r e l a t i v e

e f f i c iency o f d i f f e r en t components o f a f inancial markets, the

other two concepts a re more d i f f i c u l t to apply . Va luat ion

e f f i c i en cy i s cer ta in ly lowered by a cred it market segment which

I s sub ject to q u a n t i t a t i v e c o n t r o l s and administered p r i c e s .

However, f r ee ly functioning markets may ration cred it and keep

loan rates o f interest below th e i r market c learing leve l in a

world in which there i s asymmetric information and incomplete

contingent markets, implying some degree o f Ine f f ic iency by the

f u l l insurance c r i t e r i o n ( s ee S t i g l i t z and Weiss (1981) and

Santomero (1984)) .

10.1.4 However, while acceptLng that actual cred it markets

w i l l depart from fu l l e f f i c i e n c y , i t i s s t i l l possible to examine

the re la t iv e e f f i c i en cy o f resource al locat ion f a c i l i t a t ed by

d i f f e r en t market participants i f a set o f c r i t e r i a can be la id

down to Judge e f f i c i en cy . A crude set o f c r i t e r ia that can be

used to judge the impact o f formal and informal c red it on the

e f f i c i en cy o f factor use in the Indian situation are the r e la t i v e

magnitudes o f three r a t i o s by firms pr im ar i ly supported by

formal/informal c red i t . The ra t ios are the capltal-output ra t io ,

the labour-output ra t i o and the c a p i ta l labour r a t i o . * The

rationale is as fo llows. In the Indian situation, the formal

sector keeps rates o f interest below the ir market clearing le ve ls

and ra t ions c r e d i t through s e l e c t i v e c r e d i t c o n t r o l s .

Consequently, i t can be expected that firms with access to formal

c red it w i l l have an over ly cap i ta l intensive choice o f techniques,

which detracts from the e f f i c i e n c y o f factor use. Furthermore,

due to less than perfect c red i t rationing, In e f f i c i en t firms may

receive finance while e f f i c i e n t firms are rationed out o f the

market. In e f f i c i en t choice o f techniques are re f lec ted in the

capital-output ra t io while r e l a t i v e l y in e f f i c ien t factor use is

re f lec ted In the factor ra t ios fo r firms within the same Industry.

I t should be pointed out that low factor use ratios are neither

1. The r e l a t i v e rank ing by any two r a t i o s do not n e c e s s a r i l y d e t e r m i n e th e r e l a t i v e ra n k by the t h i r d . For e x a m p l e , suppose f i r m A has both f a c t o r output r a t i o h i g h e r than from B. The c a p i t a l / o u t p u t r a t i o r a n k i n g I s s t i l lI n d e t e r m in a t e .

su f f i c ien t nor necessary as proof o f in e f f ic iency . Furthermore,

unless there are constant returns to scale a higher capita l output

r a t i o f o r a f i rm may s imply - r e f l e c t a d i f f e r e n t sca le o f

operations compared to another f i rm .* Likewise, capita l labour

rat ios may r e f l e c t nonhomotheticity. The measures are therefore

crude. Thus, whenever i t i s possible to supplement the evidence

o f the rat ios with d irect evidence this is done.

10.1.5 Even i f i t i s accepted that formal c r e d i t leads to

in e f f i c i en t factor use, i t i s by no means clear that the informal

sector leads to r e l a t i v e l y e f f i c i e n t cap ita l use. This is since

informal credit markets are themselves imperfect and segmented.

Furthermore they can and do r a t i o n c r e d i t (by , f o r example,

lending to known parties only in some segments). Informational

considerations may also lead to suboptimal interest rates.

10.1.6 So much for factor use. I t is much more d i f f i c u l t to

judge the re la t iv e impact o f the ICM on the e f f i c iency o f resource

a l locat ion to d i f f e ren t a c t i v i t i e s . While, in an absolute sense,

segmentation and rationing imply misallocation o f resources, the

position r e la t i v e to the formal sector is s t i l l not c lear . We

r es t r i c t attention to the r e la t i v e impact o f Informal credit on

the mobilisation o f saving and the financing of I l l e g a l a c t i v i t y ,

since there can be l i t t l e doubt that greater aggregate saving in

the current context Is to be desired soc ia l ly . We now turn to the

evaluation.

10.2 Impact on the e f f i c i e n c y o f resource use

10.2.1 The rat ios are presented for three productive sectors

in Table 10.I. As can be seen, in no case do the ratios provide

unambiguous support f o r the hypothes is that in formal c r e d i t

Increases e f f i c i en cy o f resource use. More Importantly, no single

rat io supports the hypothesis fo r the item measured by i t in a l l

sectors. In fac t , in road construction, informal borrowers are

I am g r a t e f u l to T .N . S r in i v a s a n f o r these o b s e r v a t i o n s .

less e f f i c i e n t than formal borrowers by the factor use ra t ios .

Thus no firm global conclusion can be drawn.

10.2.2 Addit ional ly , a regression with interstate data o f the

capita l output ra t io on the informal credit/formal c red i t rat io

for a pooled sample o f the four RBI surveys o f f irms, revealed no

link between the two.

10.2.3 The most str ik ing piece o f d irect evidence that has

come to l i g h t concerns the f inance o f used v e h i c l e s by auto­

financiers in Namakkal and by hire-purchase firms in Delhi. Since

interest rates on such loans can exceed 40 per cent per annum, the

gross rate o f return on such veh ic les must c lea r ly be very high.

That transport operators who rece ive cheap bank finance are able

to dispense with these veh ic les , in a capital scarce economy,

suggests that informal f inance eases the bias towards the under­

u t i l i s a t i o n o f scarce c a p i t a l that a r i s e s due to the cheap

interest rate pol icy o f the formal sector. I t should be clear that

i t Ls Inappropriate to attr ibute socia l costs due to environmental

pollution or congestion, i f any, to a private sector source o f

finance.

10.2.4 In the study o f the t e x t i l e d i s t r i b u t i o n system Ln

India, where most credit and goods market transactions are j o in t l y

made, we argue in the ceport using a three-agent model based on

the sty l ised facts o f the system, that informal cred it lowers

d istr ibut ional costs and d is t r ibu tes the cost o f r isk aris ing from

demand uncerta in ty . That i s , we argue that informal c r e d i t

contributes to more e f f i c i e n t resource u t i l i s a t ion in trade.

10.3 Impact on the e f f i c i e n c y o f sectora l resource al locat ion

10.3-1 Re la t ive ly more informal fLnance goes for consumption

than formal finance. However, much o f th is credit Ls for housing

Investment. Nidhis and to a lesser extent finance corporations,

contribute d i r e c t l y to cap i ta l formation in housing construction.

Also, the majority o f consumption Loans go to groups who are asset

poor. I t Is not c lear that addit ional savings by such groups is

necessarily in the social interest at a l l times.

10.3.2 In the absence o f In formation on the in t e r e s t

e la s t i c i t y o f saving and on the degree o f subst i tutab i l i ty o f

d i f f e ren t assets, i t is d i f f i c u l t to estimate the addit ive savings

impact o f in formal f in a n c ia l markets. However, such markets

c lea r ly contribute grea t ly to gross savings and chit funds, nidhis

and P ee r less may be s ing led out for sp e c ia l mention in th is

respect. The character ist ics o f nidhis and chit funds and the

performance o f P e e r le ss , make i t l i k e l y that a d d i t i v e

contributions to savings are p a r t ia l l y re f lec ted in their deposit

f igures. Other factors that are normally held to aid savings, ILke

higher deposit interest rates, increasing extent and d ive rs i ty o f

f inancial intermediation and, in some cases higher income caused

by more productive resource u t i l i s a t i o n as with auto-finance, are

c lear ly present.

10.3.3 Regarding the fLnance o f I l l e g a l or undesirable goods

and foreign exchange rackets, there is a clear presumption that

informal credit markets lead to a greater provision o f such goods

than would otherwise be the case. However, by i t s very nature,

such a c t i v i t y is hard to assess quantitat ive ly ( f o r qual i ta t ive

evidence see Chapter 14). However, i t should be noted that

'market rumours' o f formal sector financing are equally prevalent.

10.4 Information arbitrage e f f i c i en cy

10.4.1 While f ragmentat ion o f the informal c r e d i t market

ensures that they are functionally In e f f i c i en t , examples o f eas i ly

a v a i l a b l e a rb i t r a g e oppo r tu n i t i e s can be found fo r formal

f inancial markets as wel l (See for example Das-Gupta 1989). On the

other side o f the balance, the case o f 'p ig gy back' intermediaries

for l i f e Insurance shows how the Informal sector takes advantage

o f arbitrage opportunities due to formal and Informal sector price

d i f f e r e n t i a l s .

10.5.1 D i f f i c u l t i e s in decomposing loan interest rates for

s imilar loans by intermediaries makes i t Impossible to d i r e c t l y

compare r e la t i v e establishment costs. However, three pieces o f

evidence indicate that informal sector intermediaries are more

functionally e f f i c i e n t than banks.

10.5.2 F i r s t l y , the impressions o f a l l researchers who have

examined the problem i s that establishment costs o f the informal

sec to r are low compared to the formal s e c to r . Without

quantitative government res t r ic t ions , they would possib ly be even

lower in some submarkets due to scale economies. For example, we

find that establishment costs o f shrof fs have r isen due to the

reduced sca le o f t h e i r ope ra t ions in the wake o f government

regulation. Secondly, default costs o f banks are known to be

high. Nayar (1987) report commercial bank default rates o f as much

as 70 per cent o f loans in some bank branches. Since commercial

bank loan defaults are not revealed in their published accounts,

accurate quantitat ive assessment for the sector as a whole Is not

p oss ib le . F i n a l l y , in f i e l d in te rv iew s with borrowers and

depos i to rs , with some except ions for borrowers from f inance

companies and chit funds, convenience and incidental costs for

informal credit markets were found to be smaller than for formal

cred it markets. In two cases where quantitat ive d e ta i l s could be

found or calculated, e f f e c t i v e informal sector costs to c l ien ts

were found to be lower than formal sector costs. Thus, by these

c r i t e r ia re la t iv e functional e f f i c i en cy o f the Informal market is

supported.

10.5.3 One remaining puzzle about Informal cred it costs needs

to be addressed. I t has been argued that the main component o f

informal sector interest on loans is the deposit interest rate and

opportunity cost o f own funds. But, why Is th is so with respect

3. The ca s e s a r e l o a n s to t e x t i l e w h o l e s a l e t r a d e r s and funds r e m i t t a n c e s th rough com m erc ia l In s t rum en ts v e r s u s d a rsh a n l hund i s .

to deposits cost8? Put another way, how can commercial banks,

which have high inconvenience costs to depositors and also low

deposit interest rates a t t rac t deposits despite the fact that

In formal in te rm ed ia r ies o f f e r higher deposit ra tes and, fo r

example in the case o f nidhis, an equally large array o f deposit

schemes? Is i t the case that these the In te r e s t ra te

d i f f e r e n t ia l s between formal and informal sector r e f l e c t hidden

r isk costs o f deposits wLth Informal depository Institutions?

10.5.4 Except In the case o f d epos i ts with a sec t ion o f

finance corporations, we would argue that th is is not the case.

The primary reason for the d i f f e r e n t ia l i s , we expect, the fact

that bank branches are within easier reach o f most depositors than

o f f i c e s o f In formal i n s t i t u t i o n s . Secondly , in formal

intermediaries tend to locate near the ir loan c l ien ts to enhance

information gathering potential and convenience to borrowers. In

business areas , g iven r e s t r i c t e d c red i t a v a i l a b i l i t y , the

opportunity cost o f d epos i t s would not be r e f l e c t e d by bank

deposLt rates. Current accounts with banks, o f course, re f lec t

their regulation induced monopoly for certain kinds o f payments.

10.5.5 Addit ional ly , fo r loans from friends and re la t ives (a t ,

i t has been found, upto 18% per annum), chit funds and nidhis,

high deposit rates r e f l e c t the surplus from high loan rates being

passed on to depositors. This is true by the very nature o f the

f i r s t two inst i tu t ions . In the case o f nidhis, h is to r ica l l y ,

these inst i tut ions have been set up by public sp ir i ted individuals

fo r the mutual b e n e f i t o f shareholders (which inc ludes a l l

depositors and borrowers).

10.6 Conclusions

10.6.1 While no global conclusions can be drawn, I t is clear

that in some, though not a l l , respects in formal c r ed i t does

contribute to more e f f i c i e n t resource u t i l i s a t ion part icu lar ly

from the point o f view o f functional e f f i c iency . However, i t is

d i f f i c u l t , g iv en current research, to come to an unambiguous ranking o f the formal and informal sectors.

Sector Capital- Labour- Labouroutput output capita lr a t io ra t io ratio

1. Road Construction

A l l borrowers* 0.349

Informalborrowers

Formalborrowers

0.233

0.079

2. Garment Exporters

0.23Informalborrowers

Formalborrowers

0.35

3. Power loans

A l l borrowers 0.085

Informalborrowers

1.197

3.809

1.037

0.56

0.33

0.141

0.40

0.30

3.43

16.35

13.13

2.43

0.94

4.71

2.14

Notes: 1. Includes non-borrowers and borrowers from both sources.

2. Informal Credit excludes trade c red i t :A l l firms in these sectors are substantially dependent on trade cred i t .

EQUITY IMPACT OF INFORMAL FINANCE

11.1 Evaluation c rite ria

11.1.1 The relevant c r i t e r i a here are f i r s t l y , the percentage

to ta l borrowed funds from informal credit sources received by

smaller, presumably economically weak, units both absolutely and

r e l a t i v e to la rg e un i ts . Secondly, for in te rm ed ia r ie s , the

c r i t e r i o n i s the ex ten t o f f inance go ing to economical ly

disadvantaged sections both absolutely and r e la t i v e to formal

finance. The data summarised in Table 11.1 shows that informal

finance to borrowers scores pos i t i v e ly on both counts except that

i t f a i l s the t e s t r e l a t i v e to formal f inance fo r transport

operators. However, for these units the data bias in looking only

at bank a s s i s t ed un its i s p a r t i c u l a r l y severe s ince v eh ic l e

finance ls the major cause o f borrowing. The sharp growth o f hire-

purchase (which is c h i e f l y directed at vehic le f inance) in India

shows that substantial numbers o f transport operators in India,

espec ia l ly o f used veh ic les , depend on informal finance. Thus,

overa l l the conclusion must be of a posit ive associat ion between

urban informal f inance and economically weak sections.

11.2 Cause and effect

11.2.1 Are weaker s ec t ions weak because o f e x p l o i t a t i v e

informal finance or despite It? At one l e ve l , the answer to this

question does not matter: I f borrowers can be taken to reveal

the ir preferences for some informal finance to none, then informal

f inance is c l e a r l y w e l fa re improving. However, I f I t Is

exp lo i ta t ive then th is alone is Insuf f ic ient and informal credit

should be supplanted by non-explo ltatIve sources o f credit I f

poss ib le . The d i r e c t evidence o f borrowers in studies o f

Intermediaries and in cred it using sectors referred to ea r l ie r

leads us to reject the hypothesis o f universally exploitative

informal credit, though in some re lative ly minor sectors this is

the case with urban informal finance. This is desp ite the

evidence, albeit not global, o f higher informal sector interest

rates.

11.3 SuHtary o f disaggregated findings

11.3.1 Regarding spec i f ic intermediary sectors studied, the

fol lowing b r i e f remarks summarise the position. The evidence on

chit funds, auto-finance in Namakkal, handloom finance and, to an

extent n idh is , c l e a r l y shows that these sec tors he lp small

business and small borrowers and depositors. Hire-purchase has the

opposite bias while Sanchaita and, probably, Peerless exploited

small depositors. Bhole (1985} found that trade cred it i s o f more

importance to small rather than large firms in the company sector.

F in a l l y , the p ro v i s io n o f in fo rmal f inance to the t e x t i l e

d i s t r ib u t i o n system, i t has been argued, has p o s i t i v e i n t e r ­

regional d istr ibut ion e f f e c t s .

11.4 Conclusions

11.4.1 We must conclude that Informal finance is , by and large,

welfare improving for economically weak sections. Regarding the

posit ion o f informal finance r e la t i v e to repressed formal sector

finance, i t Is worth quoting the conclusions, regarding formal

finance, o f two recent studies. L i t t l e (1987), concluding on the

basis o f a study o f small manufacturing enterprises in a se lect ion

o f developing countries ( including India) has this to say:

The tentat ive conclusion seems to be that controlled capital markets o f most developing countries are l i k e l y to pena l ize the la r g e - sm a l l or medium s i z e f irms (covering about 20 - 100 workers) that aspire to rapid growth and therefore cannot re ly on the ir own finance. Unless they are in a spec ia l ly favoured sector, e ither Interest rates w i l l be higher or access more d i f f i c u l t than with free cap ita l markets ( L i t t l e (1987), p. 221)".

Fry (1988) examines the available evidence for a selection of

developing countries (excluding India) and concludes:

"S p e c if ic a lly , fin an c ia l repression and the ensuing credit rationing worsen Income distribution and Increase industrial concentration. The evidence presented . . . . . indicates that subsidised credit policies discriminate against rather than favor small borrowers, (Fry (1988), p. 165).

Sec to r

La rg e Small

A. F ie ld S tud ies

1. Road c o n s t r u c t i o n ( I )

2. Garment e x p o r t e r s ( 1 )

B. RBI Surveys

3. S m a l l - s c a l e i n d u s t r l e s ( 3 )

4. T ra d e rs

5. T ranspo r t 0 p e r a t o r s ( 3 )

6. Households ( 4 )

93

67

55

72

31

SO

78

62

39

61

20

4 1

N o t e s : 1- Below and above the sample mean2. M a r k e t v a l u e o f f i x e d a s s e t s l e s s

than Rs I lakh3. A s s e t s l e s s than Rs 10,000.

ARE INFORMAL AND FOBMAL FINANCE COMPLEMENTS OR SUBSTITUTES ?

12.1 Three types o f situations need to be distinguished here.

1. The f i r s t type o f s i tuation is where banks do not enter or are unable to enter a particular market segment, or when in formal f inance cannot su b s t i tu te f o r bank finance. In such cases, formal and informal finance are c le a r ly complementary. Most case studies in this report found th is type o f situation prevai l ing due to banks being unable or u n w i l l in g to compete with informal lenders and also (espec ia l ly ) trade c red i t . In one case study o f a cred it using sector (road construction), informal f inancia l instruments were not acceptable as a substitute fo r bank guarantees.

i i . The second situation is when banks provide credit but up to a c e i l in g amount. In such cases, informal finance complements the credit flows to a part icular section o f c red it constrained borrowers or the credit flow for p a r t i c u la r uses. The in t e r - c o rp o ra t e funds market, f i e ld studies o f productive and trade sectors, chit fund operations, loans against jewe l le ry by nidhis and to a p a r t i a l ex tent , h ire-purchase , f a l l into th is category.

i i i . The th i rd s i tu a t io n is when banks and informal internediaries are in act ive competition. This does not appear to be the case in any loan market, though Lt is la rge ly the case for the mobilisation o f deposits by some, though not a l l informal intermediaries and. One area in which informal and formal sec tors are in competition, to the l a t t e r ' s disadvantage, is in the t r a n s f e r o f funds between geograph ica l cen tres . In formal c o u r i e r s , known as ' a n g a d ia s ' are seen as superior to banks by many businessmen.

12.2 A second finding relevant to the discussions here is the

opinion o f borrowers o f the two sources o f cred it . In a l l f ie ld

studies o f cred it using sectors and of borrowers from particular

in termed iar ies in formal c r ed i t was broadly speaking, viewed

pos i t iv e ly due usually to the expected speed and informality (and

In some cases, low cost) of informal credit while bank credit was

viewed negatively . Dockyard fin an c ie rs ln Calcutta and some

finance corporations were the exceptions.

12.3 It is d if f ic u lt to conceive o f an aggregate statistica l

exercise which w ill reveal support or the lack o f support for the

kinds of situations outlined in the f irs t paragraph. However, a

positive link between formal and informal credit, both taken as

the ra tio of some Indicator such as s a le s ,* w i l l support the

hypothesis of complementarity. In order not to re fle c t scale

effects, correlation coefficients of the two ratios mentioned

above were computed from the RBI surveys of firms using Interstate

data. The c o e ff ic ie n ts ( in percentage) were found to be as

follows:

Correlation Coe f f ic ien ts Between the Ratios o f Informal Credit to Sales and Formal Credit to Sales

( In te r State Data)

Small-scale industry 61.04 (n=14)

Wholesale trade 39.46 (n=»19)

Reta i l trade 29.25 (n=19)

Transport operators -3.42 (n-18)

Thus, the hypothesis o f complementarity finds weak support

in the case o f small-scale industry alone, but has the right sign

for trade. The aggregate evidence may be taken to be Inconclusive.

12.4 Thus, given the current state o f banking, complementarity

is supported by micro studies but not necessarily by the regional

evidence. Given the discussion in th« previous paragraphs, i t

would appear that the formal and informal sector specia l isat ion in

some areas iden t i f i ed in the micro studies should be de l ibera te ly

strengthened.

1. RBI su r v e y s o f p r o d u c t i v e u n i t s s t r o n g l y su gges t e c o n o m ie s o f s c a l e in t o t a l c r e d i t use so t h a t c r e d i t f i g u r e s need to be c o r r e c t e d f o r s c a l e by u s ing f i g u r e s such as f o r t o t a l s a l e s .

12.5 AC the aggregate le v e l, defin ing complementarity and

substitutability by the usual cross e lastic ities is feasible.

Thus, i f an expansion in bank credit (o r a lowering of bank loan

rates with no in terest rate con tro ls ) leads to a decline in

informal credit, other things equal, then they atfe substitutes.

Furthermore, other things equal, i f an increase- in bank deposit

rates causes informal credit demand to decline they are, once

more, substitutes. The available evidence, cited at the beginning

of the next chapter, is mixed.

INPORMAL CREDIT AND MONETARY POLICY

13.1 Prior evidence and issues

13.1.1 Does informal c r e d i t f r u s t r a t e short-run monetary

policy? Limited evidence is ava i lab le on this issue. Acharya and

Madhur (1983) argue that excess demand for constrained formal

cred it s p i l l s over into the ICM dr iv ing up ICM loan rates in times

o f r e s t r i c t i v e central bank operations thus leading to an overa l l

cred it squeeze. They test th is with data re la t ing to 'bazaar b i l l

rates ' ( th is RBI data series was discontinued In 1977) and find

support for th e i r hypothes is . Sundaram and Pandit (1983)

c r i t i c i s e the data used by Acharya and Madhur and show that the

conclusion is sensit ive to the data series used. The debate in

lad La between Acharya and Madhur on one side and Sundaram and Pan­

d i t on the other Ls inconclusive-

13.1.2 Fry (1988) c i tes studies re la t ing to the Korean economy

and concludes that time deposits in the formal sector are closer

substitutes to assets which are primarily in f la t ion hedges ra l ’i i r

than to curb market loanable funds which are r e la t i v e l y insensi­

t i v e to time deposit rates In a three asset por t fo l io model. On

the basis of the econometric evidence he concludes that

. . . .an Increase in the time deposit rate o f interest would lead to an increase rather than a decrease in the to ta l supply of credit in real terms", (Fry (1988), p. 161) .

Edwards (1988), studying the Korean economy, finds a pos i t ive l ink

between deposit bank time rates and curb market loan rates.

13.1.3 The relevant Issues, Co our way o f thinking, revolve

on five points.

1. Does lower money supply (Including bank credit) neces­sa r ily lead to a f a l l in -tota l credit ava ilab ility (o r can informal credit counteract this su fficiently )?

11. A related point, do movements in the bank loan Interestrates lead to general movements in Informal loan Interest rates or credit in the same direction?

i l l . Is the opposite of ( i i ) true for bank deposit rates?

iv. Can selective credit controls, which are used In India, bee ffective ly Imposed in the face of informal credit?

v. Even i f a l l four questions are answered In the affirm­ative, is the credit multiplier the same as It would be inthe absence of Informal credit (o r is it lower or lessprodlctable)?

I f the answer to a l l five questions is in the affirmative then the

hypothesis that informal credit frustrates monetary policy can be

rejected.

13.2 Evidence

13.2.1 F irstly , the sheer size of Informal credit markets and

their like ly rapid growth argues against points ( iv ) and (v ).

Secondly, the links with the black economy (see below, chapter 14)

and the estimated size of productively deployed black funds

(Chapter 8) strengthen this position. Thirdly, the rapidity with

which informal credit is deployed could go against the third point

above for short run monetary policy but is not, by Its e lf , con­

c lu s ive . While detailed time series evidence Is lacking, the

evidence in Tables 13.1 and 13.2 tends to argue against the first

two points for short run monetary policy except In the case of

nldhls who make up only a small part o f the informal credit system

(Chapter 8, Table 8.2). However, over a longer horizon, Interest

rates in informal and formal sectors do appear to move together.

13.2.2 To go Into sectoral d eta il, the following observation may

be made. Except for the inter-corporate funds market, no evidence

has been found of short run responsiveness of Informal credit to

formal interest rates or c red i t a v a i l a b i l i t y . However, the cross

section nature o f the study is a l im i ta t ion that has to be kept In

view. The hypothesis that the inter-corporate market increases the

v a r i a b i l i t y o f the money mult ip l ie r and reduces the e f fec t iveness

o f s e l e c t i v e c r e d i t c o n t r o l s has been advanced in the repor t

though the evidence i s not o f the type permitting a f irm conclu­

sion to be drawn.

13.2.3 Trade c r e d i t and on- lend ing in genera l r i s e s ser ious

doubts on the e f fec t iveness o f s e le c t i v e controls. The findings o f

Bhole (1985) may be c i ted fo r other points. Bhole used Reserve

Bank o f India data on the company sector for the years 1952 to

1978 to study the impact o f trade cred i t on monetary po l icy . In

the study he examined in ter a l i a , the e f f e c t o f the short run bank

lending rate and bank cred i t a v a i l a b i l i t y on trade dues, trade

receivables, net trade credit and the credit period o f dues and

r e c e i v a b l e s in days. His r e s u l t s g i v e a f f i r m a t i v e support to

po ints (1 ) and ( i i ) above though the evidence Is not always

robust. However, his f indings tend to re jec t an a f f i rmat ive answer

to point ( i v ) . There were some d i f f e r e n c e s between d i f f e r e n t

groups o f companies fo r the impact on the volume o f trade credit

though not the cred it period. In sum, hLs results argue for a

weakening of the p red ic tab i l i t y o f monetary pol icy for the company

*sector but not for I ts frustrat ion in terras o f d irect ion.

13.2.4 In conclusion, the l imited evidence presented here argues

for a weakening o f the Impact o f monetary pol icy with the informal

sector either unresponsive or, in the case o f trade c red i t , coun­

t e r a c t in g monetary p o l i c y . However, complete f r u s t r a t i o n o f

monetary po l icy cannot be Inferred from the evidence here. Tae

question Is, therefore, s t i l l open.

13.3 Towards a short run macronodel with Informal credit markets

13.3.1 Work on macro models with informal credit Include work by

Rakshit (1982, 1987), Taylor (1983), Van Wijnbergen (1983), Buffie

(1984) and Chang and Jung (1984). Of these, the work o f Rakshit

is based on the s ty l ised r e a l i t i e s o f Indian experience.

13.3.2 Rakshit (1982) examines the consequences o f informal

cred it in a model in which a p ivota l ro le i s played by wholesalers

who demand cred it fo r inventory investment and who have access to

both formal and in formal (o rgan ised and unorganised in his

terminology) loan markets. The supply o f organised sector loans

is f ixed exogenously as is the interest rate. Demand for loans

then depends on the return to inventory investment r e la t i v e to

loan rates and the formal sector constraint. Since the supply o f

formal loans is rationed, there is a discontinuous demand function

for informal loans. He then goes on to show how a change in bank

loans can e ither raise or lower informal rates depending on i f the

supply curve o f informal loans passes through the discontinuity in

the demand curve or not. However, expansion (contract ion) In bank

credit does result in more ( l e s s ) c red i t to wholesalers. I t is

d i f f i c u l t to determine i f th is result w i l l continue to hold in the

face o f s ty l ised facts of Indian ICMs thrown up by th is study to

rftich we now turn.

13.3.3 An important sty l ised fact that must be taken note o f in a

properly spec i f ied macro model i s the fact that formal sector in­

terest rates have l i t t l e r e la t ion with Informal ra tes . On the

deposit side th is i s because o f l im ited access by most depositors

to informal deposit channels due mainly to geographic or Informa­

t ional barr iers. On the loan side th is i s because o f formal sec­

tor credit r e s t r ic t ions .

13.3.4 A second s ty l ised fact i s the existence o f imp l ic i t con­

tracts ( long standing re la t ions ) in markets for trade and some­

times production finance leading to stable nominal Informal inter­

est rates.

13.3.5 A third fact Is that informal markets are subject to quan­

t i t a t i v e controls on deposit taking and interest rate res t r ic t ions

in some cases.

13.3.6 The consequences o f fragmentation and links with the black

economy must also be explored. Dasgupta and Ray (1989) study ag­

gregate demand with a black economy but without an 'w h i t e ' in fo r ­

mal market. Rakshit (1987) studies fragmentation.

13.3.7 Clearly, adequately accounting for these factors in a par­

simonious macro model is no easy task. However, i t is essent ia l to

attempt such a task i f proper appreciation o f the short run impact

of ICMs is to be had.

Growth In Aggregate Advances/Credit o f In fo rm a l In t e rm e d ia r ie s and Banks, 1982-1986

( P e r cen t per annum)

Yea r Bank N idh i s F inanceC o r p o r a t i o n s

Chit Fund s

198 2 17. 68 (1 • 3) ( 0 . 1 4 ) 33 . 1

1983 19. 54 14. 47 ( 5 . 0 9 ) 9 .2

198 4 15. 75 11 . 2 ( 1 8 . 6 6 ) 67 .6

1985 17. 90 52. 2 ( 1 5 . 5 5 ) 15.4

1986 14. 52 21 . 7 ( 1 3 . 8 1 ) 56.7

Rankc o r r e l a t i o n w i th Banks

100 90 30 -9 0

Not e : N e g a t i v e f i g u r e s in p a r e n th e s e s .

Source s : 1.

2.3.

RBI, Repor t on Currency & F in an ce , V a r io u s I s s u e s . F i e l d Surveys .RBI, surveys o f d e p o s i t s w i th non banking companies , v a r i o u s i s s u e s -

( P e r cen t per annum)

Y ea r Bank Financec o r p o r a t i o n s

Hi r e -p u r c h a s e corapan i e s

S h r o f f s

1970-71 9.3 NA 18-30 15

1980 16.5 NA NA 18

1 982 16.5 18-29 NA NA

1 983 16.5 19-31 NA NA

1 98 4 16.5 22-33 35 NA

198 5 16-5 25-36 37 NA

1986 17.5 32-3 7 38 NA

1988 16.5 NA 38 21

S o u rc e s : As in T a b le 13-1 n o t e s 1 and 2 and Bombay S h r o f f s A s s o c i a t i o n .

TWO ISSUES: COMPLEMENTARITY AND LINKS WITH THE BLACK ECONOMY

14.1 The McKinnon (1973) complementarity hypothesis*

14.1.1 By th is hypothes is , f i n a n c ia l and physica l asse ts are

complements due to the existence o f c red i t constraints and low in­

terest policy as part o f repressive formal sector po l icy . This

happens since an increase in the supply o f credit adds to the

stock o f f inancial assets and while stimulating greater investment

a c t i v i t y . The hypothesis has received limited support from cross

section intercountry studies (Gonzales Arr ie ta , 1988). While for­

mally a macro-economic hypothesis, i t would find support at the

microeconomic leve l i f investment by firms was limited by cash in

advance constraints made binding due to supply constraints on

c red i t . Net funds for the purchase o f productive factors (as dis­

tinct from raw materials or stock in trade) are l imited to own

funds on average, in road construction and for trading agents in

t e x t i l e wholesale markets (Table 14.1). Hius for spec i f ic sectors

in India, support fo r this hypothesis ex is ts . Indirect evidence

that such a s i tu a t i o n p r e v a i l s fo r handloom weavers is a lso

present. At another l e v e l , purchase o f productive capita l in the

second hand commercial vehic le markets would appear to be less

prevalent in the absence o f informal finance. We may ten ta t ive ly

conclude that the hypothesis i s va l id for a part o f the Indian

economy, though at the macro-level, no conclusion can be drawn on

the basis of th is study.

1. See , among o t h e r s , McKinnon ( 1 9 7 3 ) , Fry ( 1 9 8 8 ) , Gonza les A r r i e t a (1988 ) and Shaw (1 9 7 3 ) .

14.2.1 Informal intermediaries studied would obviously not reveal

any finance o f i l l e g a l a c t i v i t y . "Market rumours" indicate such

a c t i v i t i e s on the part o f f inance corporations, some indigenous

bankers and some traders. The Sanchaita and Peerless cases threw

up c lear indications o f l inks with the black economy, with these

inst i tut ions a l leged ly generating black funds and also providing

" e f f i c i e n t ” means to launder funds. A l l c r e d i t using s e c to rs

employed suspected i l l e g a l funds in the guise o f informal cred it

(usually from fr iends and r e la t i v e s ) , a suspicion that f inds sup­

port for the aggregate economy (Chapter 8 ) . In fact , the volume o f

laundered black funds Is estimated to be almost equal in s ize to

to ta l informal c red i t (Chapter 8 ) . The f i lm finance study reports

on black payments in the sector. F ina l ly tax evasion by in te r ­

mediar ies and most f irms is g e n e r a l l y b e l i e v ed to be w ide ly

prevalent in India (Acharya and Associates, 1985). While black

economy links have not been a central part o f our f i e l d inves t iga­

tions, some evidence o f l inks, perhaps strong ones, ce r ta in ly ex­

is ts . ADB (1985) expresses the opinion that most black money

remains outside the formal credit market. Furthermore, they point

out that black funds do play a pos i t iv e role in promoting saving

and investment given formal sector r i g i d i t i e s .

14.2.2 Methods by which informal c red i t markets f a c i l i t a t e trans­

actions in the black economy have been discussed in some d e ta i l by

Alyar (1979) and b r i e f l y by Timberg and Aiyar (1980). The main

points made by them are the fo l lowing

a. Black transactions take place through both formal and in­formal cred it markets. Informal markets do not have any necessary l ink with the black economy and a l l submarkets do not f a c i l i t a t e black transactions.

b. The f i lm industry , c o n s t ru c t io n , h o te l indus try and transport sector r e ly heavi ly on black funds.

c. The main s e r v i c e o f in fo rm a l in te rm ed ia r ie s i s to f a c i l i t a t e payments for i l l e g a l goods through bank sight drafts while allowing transacting parties to reta in the ir anonymity. The annual volume o f such remittances in 1979 is estimated at Rs 450 crore in Bombay alone and Rs 750

d. The p ro v i s io n o f brokerage s e r v i c e s , by s p e c ia l i s e d brokers for the placement o f black funds. Loan defaults for black money loans were almost unheard o f even i f white debts were defaulted. The interest rate on such loans was from 12% to 15% in 1979.

e. Records o f black transactions on instructions for disposal o f black funds were usually on scraps o f paper and in in­novative and o f t changing codes.

f . The provision o f bogus rece ip ts or book entr ies allowing the laundering of black funds or the concealment o f in­comes by recording fake expenditure - both fo r a fee. Anagent for these transactions is known as an Havala.

g. The f a c i l i t a t in g of ' k i t e f l y i n g ' operations by taking ad­vantage o f bank cheque discounting and delays in bank co l ­lec t ion o f outstatlon cheques. This service is reported to be provided by finance corporations in Kerala. Road receipts and le t t e rs o f c red i t are s imilar ly used.

h. Remittances o f cash through Angadias.

i . Evasion o f foreign exchange res t r ic t ions through overseascorrespondents and arrang ing p r iv a te remittances ( the agent in India accepts rupees fo r remittance and pays out rupees remitted while the correspondent does the same in the fore ign currency. No actual funds flows take p lace ) .

14.2.3 On the basis o f this evidence, l imited though i t i s , we

must conclude that the informal f inanc ia l sector as a whole serves

the black economy and employs black funds. However, i t should be

emphasised that not a l l in formal submarkets serve the black

economy. Nor are l inks with the black economy limited to the in­

formal sector. When the pos i t ive features o f informal c red it are

weighed against the negative i l l e g a l l inks , the need for a sector

by sector approach to regulation gets emphasised.

( In percentage o f to ta l assets )

Sector Roadconstr­uction

Garmentexpor­ters

Power-looin

Aratlyast e x t i l etrade

Tex t i l ewholesaletraders

Loans and advances

43 39 26 72 57

Borrowed funds 38 70 59 82 37

PART D

INFORMAL CREDIT MARKETS IN RURAL INDIA

INFORMAL CREDIT MARKETS IN RURAL INDIA

15.1. Introduction

15.1.1 Informal cred it markets in rural India, unlike urban informal

cred i t markets, have been studied on a more or less sustained basis

during the past four decades. The exp lo i ta t iv e v i l l a g e moneylender and

the indebted rural peasant have, in fact , become a part o f the commonly

held view o f backward South Asia agriculture. Besides several studies

by in d iv idu a l scho lars , many o f them ve ry we l l known, systematic

information on the finances o f rural households has been co l lec ted by

the Reserve Bank of India through i t s decennial surveys, the f i r s t of

which was carried out in 1951. Reduction o f the dependance o f rural

households on informal credit and expansion o f the overa l l supply o f

rural credit has also been a major goal o f government pol icy . Measures

include the setting up of an apex development bank, commercial bank

branch expansion in rural areas, establishment o f special ised financing

agenc ies at var ious l e v e l s o f government and strengthening o f

cooperative f inancing. Moneylenders acts and related l e g is la t ion have

also been enacted at various times since the beginning of th is century

to curb usury and informal lending in general.

15.1.2 As a r e s u l t o f these measures and a lso the gradual

modernisation and development o f rural India, various changes have come

about in rural f inancia l markets.

15.1.3 This chapter provides a b r i e f overview o f changes during the

recent past and the current state o f rural informal credit markets. The

chapter is la rge ly based on the study o f rural ICMs conducted as part o f

th is study of ICMs by a team from the Centre for Development Studies

(CDS), Trivandrum. The CDS study made use o f e a r l i e r studies and

secondary data, besides conducting a questionnaire based survey o f six

v i l l a g e s . The object ives o f the CDS study were based on the common terms

o f reference discussed in Chapter 1 o f th is summary report.

15.1.4 The chapter i s organ ised as f o l l o w s . The next s e c t i o n

examines the aggregate s i ze and trends in s ize o f rural c red i t markets

and also interstate var ia t ions in the importance o f informal c red i t .

Section 3 describes the CDS sample design and describes character is t ics

o f ru ra l household, debt and f i n a n c i a l sav ing . I t a ls o desc r ib e s

c h a r a c t e r i s t i c s o f in formal c r e d i t in the sample v i l l a g e s . The

discussion is supplemented where necessary by s e lec t iv e references to

e a r l i e r studies. Section 4 examines the structure o f informal c red it

markets in the sample v i l l a g e s and also as described in e a r l i e r studies.

The section includes a consideration o f evidence o f fragmentation,

interl inkage o f credit and other markets and determinants o f interest

rates. Section 5 describes the operations o f professional moneylenders,

the largest commercial source o f informal loans in the sample v i l l a g e s .

Section 6 uses sample data and ea r l i e r studies to draw some inferences

about the a l l o c a t i v e and w e l fa r e impact o f rural in formal c r e d i t .

Concluding remarks are in the f ina l section.

15.2. Size and trends in s ize o f rural f inancia l markets

15.2.1 The major sources o f data on the finances o f rural households

in India are the Reserve Bank of India 's A l l India Rural Credit Survey,

1951 and the three rounds o f the A l l India Debt and Investment Survey

(AIDIS) in 1961-62, 1971-72 and 1981-82. These sample surveys were

based on A l l India s t r a t i f i e d samples o f households. The AIDIS rounds

examine both assets and l i a b i l i t i e s o f households as well as borrowing,

saving and investment during the reference year. Summary data from the

AIDIS are presented in Table 15.1.

15.2.2 Before exauinin^ the Table, i t is worth pointing out that

there are doubts as to the comparability o f the data from d i f fe ren t

rounds o f the survey due to d i f f e r e n c e s in sampling procedures.

Essent ia l ly , (see the CDS Report, Appendix 1) , the sampling procedure

adopted, while generating re l iab le estimates o f quantit ies per reporting

household, underestimate the household inc idence o f any sampled

character is t ic . Furthermore, the problem of underestimation has been

in c reas ing In s e v e r i t y between d i f f e r e n t rounds. By im p l i c a t io n ,

in ter tem pora l trends re vea led by the data are suspect but not

necessari ly cross section patterns. This caveat should be borne in mind

while examining the data.

15.2.3 Parts A and B o f Table 15.1 present intertemporal trends in

cash dues outstanding o f rural households. The data show that the real

size of rural household debt has been decreasing between 1961 and 1981

(us ing the wholesale p r ice index as the d e f l a t o r ) , the decrease

a c c e l e r a t in g over the second decade. However, debt per repo r t ing

cu l t iva tor household (Part C.2) has increased both in nominal and real

terras during these decades- As discussed above, intertemporal trends,

except those per reporting household are l ik e ly to be biased downward.

15.2.4 The share o f in formal c r e d i t to households has decreased

markedly from 85 per cent in 1961 to 39 per cent in 1981. I t i s l i k e l y

(CDS (1988), p .23) that this r e f l e c t s an actual decrease in the quantum

o f rural credit to households and a shrinking rural c red it market (Part

E).

15.2.5 Of the var ious types o f informal lenders , a g r i c u l tu r a l

moneylenders may be seen to be losing ground to other lenders. While

they were the most important group of lenders in 1961, r e la t i v es and

f r i ends have th is p o s i t i o n in 1981. Among commercial l enders ,

p ro fe s s io n a l moneylenders had almost the same market share as

agr icultura l moneylenders in 1981 though the ir share in 1961 was only a

third o f that o f agr icu ltural moneylenders.

15.2.6 F ina l ly the proportion o f borrowing households continues to be

higher for cu lt ivators and the gap between the proportion o f indebted

cu l t iva to r households and non-cultivator households has been increasing

(Part F) .

15.2.7 Turning to statewise de ta i ls , Table 15.2 shows that the share

o f informal credit has declined in a l l states over the past two decades,

though the rate o f decl ine has not been uniform. Consequently, changes

in the rank o f States according to the importance o f formal c red it have

taken place. The most dramatic change has been that o f Assam which

moved from the third lowest rank in 1961 to the f i r s t rank in 1981.

15.2.8 The share o f in formal c r e d i t i s found to have a n e g a t i v e

corre la t ion with per capita rea l State domestic product (-61.01 per

c en t ) but, on the other hand, the ra te o f d e c l in e o f the share o f

informal credit has a negative corre la t ion with both the rate o f growth

o f per capita l real State domestic product and the growth rate o f per

capita rea l state domestic product from agriculture (the l a t t e r being

-51.22 per c e n t ) . Thus, wh i le in formal c r e d i t i s a s so c ia t ed with

backwardness, i t s rate o f decl ine Is slower in more developed s ta tes .

15.3. Informal credit to households in surveyed v illages

15.3.1 The aggregate data presented in the previous section provide

no indication as to character is t ics o f loans from various lenders and to

d i f f e r en t classes o f households. I t also f a i l s to provides evidence on

the nature o f rural informal c red it markets. To study these features, a

f i e ld survey was conducted by the CDS in six v i l l a g e s in Kerala and

Tamil Nadu. The survey was limited in coverage due to f inancial and time

c o n s t r a in t s . However (T ab le 15 .3 ) , a d e t a i l e d ques t ionna ir e was

administered to 408 households selected by s t r a t i f i e d random sampling

and 30 informal lenders. The survey v i l l a g e s were selected to ensure

d iv e r s i t y o f v i l l a g e types.

15.3.2 Table 15.4 the l i s t s main findings o f the survey regarding

cash debt o f households. As can be seen (Part A), the r e l a t i v e l y small

s ize o f the informal market para l le ls the findings o f the AIDIS, though

the r e la t i v e s ize of the informal sector is smaller than that reported

by the AIDIS. However, (Part B ) , when the posit ion o f borrowings during

the year rather than debt outstanding at the time o f the survey is

examined, the share o f the informal sector is more s ign i f ican t and even

larger than the formal sector in the case of agr icu ltural and other

casual labour. The other major d i f fe rence is the disproport ionate share

o f r e la t i v e s and friends in informal c red i t in contrast with the AIDIS.

15.3.3 Kurup (1976) has also studied the cred it economy o f a v i l l a g e

in Kerala. He found, at the time o f his survey, that informal credit

from 'non-profess ional ' moneylenders was the most Lraportant source o f

c red i t (57 per cent) and that informal credit was far more important

than formal cred it (86 per cent ) . Thus, granted that CDS (1988) and

Kurup (1976) studied d i f f e r en t samples, a lbeit from the same general

a rea , these micro s tud ies tend to support the d e c l in e in informal

markets found at the aggregate le ve l .

15.3.4 Further evidence comes from the study by Bhende (1983) who

found, for 3 v i l l a g e s in Andhra Pradesh and Maharashtra in 1975-76 to

1977-78, that in 2 o f the 3 v i l la ges formal c red it to households was

dominant. Even in the th ird v i l l a g e , formal credit formed 47% of tota l

credit to households.

15.3.5 Turning to c h a r a c t e r i s t i c s o f Informal loans to sample

households, Parts C to F o f Table 15.4 provide relevant de ta i ls o f

loans to households. From the table i t can be seen that most loans are

small ( l e s s than Rs 1500) and for short periods ( l e s s than one year ) .

In fac t , In some cases, loans for less than a week were found. Across

v i l l a g e s , the average corre lat ion coe f f i c ien t between s ize and duration

o f loans was 24% with a s ign i f icant pos it ive c o e f f i c i en t being observed

in only one case.

15.3.6 About 60 per cent o f loans were secured with over ha l f o f

these being secured aga inst immovable property . Thus, the usual

presumption that the majority o f informal loans are unsecured is found

not to be supported. However in the sole v i l l a g e In the sample where

Informal c red it was dominant (Thirunavaya), 95 per cent o f Informal

loans were against personal security. Thus, the hypothesis can be

advanced that easy access to formal loans increases the r isk o f default

to informal lenders. This hypothesis Is worth examining In future

stud ies.

15.3.7 As is to be expected, Informal credit is cos t ly , with annual

interest rates ranging up to 500 per cent ( th is from a professional

moneylender ) . However, the la r g e p ropor t ion (29 per c en t ) o f zero

interest loans ( l a r g e ly , but not en t i r e ly , from friends and r e la t i v e s )

is also to be noted. In one case, zero Interest loans from traders were

described In the CDS report with loan repayment being In kind but at the

market price prevai l ing for the crop in question, at the time o f loan

repayment. In general most loans and loan repayments were in cash

though Instances o f loans In cash or kind with repayment In kind the

repayment being valued below the prevail ing market price, were found.

Regression exercises were carried out to study variat ions In interest

r a t e s . The broad conc lus ion was that " . . . e s t i m a t e s r e f l e c t the

h e te rogen e i ty o f Informal c r e d i t markets .........R e l a t i v e l y few

ge n e ra l i s a t i o n s can be made". That the source o f loans was an

important determinant o f interest rates was the main finding o f these

exerc ises .

15.3.8 The d is tr ibut ion o f loans by source and Interest rate Is In

Table 15.5. The table shows that professional moneylenders had both

the greatest proportion o f high Interest loans and the highest average

rate o f Interest.

15-3-9 Final ly , we may examine assets o f simple households. Table

15.6 shows that the bulk o f household f inancia l saving was In the formal

sector, though ( f i gu res are not reported here) f inancia l assets o f

sample households were very l imited in contrast with non-finaneial

asse ts .

15.4. The structure of rural Lnformal credit markets

15.4.1 In a l l surveyed v i l la g es , there was more than one informal

lender , though a l l households did not have access to a l l lende rs .

Detai ls o f operations o f 18 Informal lenders are In Table 15.7. The

d ive rs i ty o f Informal lending operations is evident from this table .

Three unusual features which are worth highl ighting are: (1 ) s ix lenders

borrowed on occasion from other moneylenders or traders and even the

banking sector with none o f these lenders accepting regular deposited;

(2) o f lenders who provided Information on defaults , many had f a i r l y

subs tan t ia l l e v e l s o f d e f a u l t s ; (3 ) 5 lenders r e l i e d p r im a r i l y on

deposits for the i r loanable funds. In addition, in Individual cases,

in terest ing examples o f innovative business practices were reported.

Thus, one moneylender (Row I ) co l lec ted weekly repayments from door to

door; a f inance company gave zero interest loans on occasion to door; a

f inance company gave zero Interest loans on occasion agricultural labour

(Row 12); another f inance company v is i t ed a v i l l a g e i t served every

Friday from a neighbouring town. In general, Interest rates reported by

lenders were lower than interest rates on loans reported by borrowers.

But borrowers attested to the speed, f l e x i b i l i t y and lack o f formali ties

o f informal lenders, though In two sample v i l l a g e s which were hurt by

the fa i lu re o f some finance companies (see Chapter 9 above), respondents

expressed serious reservations about informal lenders. There was also

general d issa t is fac t ion with high interest rates.

15.4.2 The responsiveness o f Informal lenders to borrower needs has

been found by other researchers as we l l . To quote Desai (1976) who

studied credit in a t r iba l area o f Gujarat,

" . . formal agencies have been unfunctional in the ir role. Against th is , the Informal lenders have played a va r ie ty o f ro les In the economic l i f e o f the t r i b a l s through th e i ramazing f l e x i b i l i t y in e v o lv in g terms and cond i t ions o fc r e d i t ” (Desai (1976) p. 90).

A similar conclusion is reached by Bhende (1983) fo r one o f his sample

v i l l a g e s .

15.4.3 That rural loan markets in India are fragmented, In the sense

that d i f f e ren t rates o f Interest prevai l fo r loans with essen t ia l ly

similar character is t ics to s imilar borrowers, is well accepted. Bhende

(1983) reaches th is conclusion for his study areas. Rudra (1975)

provides data on sources o f loans open to various types o f borrowers in

76 West Bengal v i l l a g e s in the early 1970's. His data show that farm

servants and casual labourers had access to fewer sources o f c red it ( f o r

general purpose loans) than tenants (Rudra (1975), p. 1052). Kurup

(1976 ) , a ls o p rov ides data which in d ic a t e fragmentat ion . For the

present survey, wh i le l im i t ed d e t a i l s are a va i l a b l e on access o f

d i f f e r e n t borrowers to d i f f e r e n t lenders (T ab le 15.7, column 2 ) ,

var ia t ion in interest rates across loans, for the same type o f security

(Table 15.8), provide some evidence o f fragmentation.

15.4.4 Another fea ture o f rura l c r e d i t markets In Ind ia that Is

widespread Is th e i r in t e r l ln k a g e with fa c to r and output markets.

Evidence on Interltnkage with various markets has been put forward among

others, by Bharadwaj (1980), Bhaduri (1977), Bardhan (1980), Bardhan and

Rudra (1981, 1983), Harrlss (1982), Rudra (1976), Bhende (1983), Sarap

(1986), Pant (1980), Kurup (1976) and Roth (1979). Such Interl inkage

has been seen by some o f these authors to enable lenders to extract

greater rents from borrowers than would be possible through the cred it

market a lone while o thers see such loans as w e l fa re Improving f o r

borrowers (the two views are not mutually exc lus ive ) . In the study

areas, while no case o f Interlinked cred it and land lease transactions

were found, Instances o f Interl lnkage o f c red it and commodity markets

and credit and labour markets were reported. While in one case o f tied

commodlty-credlt transactions (rubber cu l t iva to rs and traders in Anlkad)

a d d i t i o n a l rent e x t r a c t i o n by lenders i s c l e a r l y absent due to

compet i t ion among lenders (CDS (1988), p. 122), in o ther cases

(vegetable cu lt ivators and traders In V i lp a t t i ; f ish middlemen and boat

owners In Thallkulam, fishermen and boat owners in Tha l lku lam ),

extraction o f additional re i ts through t ied transactions cannot be ruled

out -

15.4.5 The d ive rs i ty in the structure o f informal credit markets is

by no means exhaust ive ly descr ibed by these paragraphs. Two

inst i tut ions which are prominent in the study areas are chit funds and

finance companies. As shown in Table 15.6, a f a i r p roport ion o f

f inancia l savings in the Informal sector are with chit funds. However,

due to the recent fa i lu re o f several finance companies in the study

area, discussed in Chapter 9, the popularity o f finance companies is on

the decline. Again, this Is re f lec ted in Table 15.6. Among the

d i f f e r en t types o f credit arrangements, mention must be made o f the

inst i tu t ion o f reciprocal loans among fishermen in Kerala. Platteau

e t . a l . (1983) study th is unusual c red it 'market' among subsistence

fisherman in three Kerala v i l l a g e s .

15.4.6 To complete our description o f market structure, the formal

c red i t Inst i tut ions In the study area need to be described. The sample

v i l l a g e s are served by between 1 and 6 formal credit out lets (average

four) including commercial banks and bank branches, cooperative banks

and a land mortgage bank. Of these, two formal Inst itut ions were looked

upon with great favour by respondents. These two inst i tut ions appear to

be competing s u cc e s s fu l l y for the custom o f r e s id en ts o f t h e i r

r e s p e c t i v e v i l l a g e s . However o ther i n s t i t u t i o n s were fa r l e s s

successful: one was facing bankruptcy; others, in a v i l l a g e that had

faced a major agr icultural reverse ( V i l p a t t l ) , had "almost suspended the

grant o f fresh loans" (CDS (1988), p. 76) due to high defaults; several

cases o f high defaults , poor service, outright corruption and fa i lure to

meet the needs o f the poorest households have also been reported In the

study. Thus, though successful formal agencies are not t o ta l l y absent,

the general picture o f the formal sector is bleak.

15.5. Operations o f professional moneylenders

15.5.1 As has been seen (Tab le 15 .4 ) , loans from p ro fe s s ion a l

moneylenders have the la rg e s t share o f commercial Informal loans.

Consequently, the r ich Information on opera t ions o f p ro fe s s ion a l

moneylenders in the CDS report is worth summarising. Various types o f

loans, from dai ly repayment loans to longer term loans provided by

moneylenders have already been alluded to. To summarise, d i f fe rent

moneylenders have d i f f e r en t groups o f customers whom they serve, o f f e r

d i f fe ren t types o f loans In terras o f Interest rates, security, duration

and terras o f repayment and may or may not accept deposits. Interest

rates for both deposit and loans are uniformly higher than formal sector

rates, though the var ia t ion in loan interest rates is very large.

15.5.2 In Table 15.9 a s t a t i s t i c a l p r o f i l e o f a sample o f

professional moneylenders In the study area Is provided. Part (A) o f

the table shows that most loans from moneylenders went to agricultural

and casual labour, though the bulk o f loan funds flow to cu lt iva tors .

The former paid high interest and the la t t e r r e l a t i v e l y low Interest on

loans taken.

15.5.3 Consumption loans (but not n e c e s s a r i l y t o t a l consumption

c red i t ) accounted for over 50 per cent of the loans and also carr ied the

highest Interest (Part B ) . Likewise the average interest on small loans

was the highest (Part C ) . By implication, agr icu ltura l labour are the

recipients o f these high interest though small consumption loans. The

d istr ibution o f loans by asset class (Part D) shows that the bulk, o f

loans goes to the wealthiest group at the lowest average In terest ,

though neither the average loan size nor the average interest rate is

raonotonically re lated to asset class. F ina l ly , as would be expected,

unsecured loans carry much higher interest than secured loans (Part s ) .

Overall, moneylenders serve a l l types of agents in the study area with

the bulk o f their funds going to the r e la t i v e l y wealthy cu l t iva tors but

most o f the ir borrowers coming from the poorer classes.

15.5.4 Further insight into the operation o f moneylenders can be

gained from an examination of th e i r f inances and attempting a

decomposition o f the spread between their deposit rates. The CDS study

analyses the spread between loan and deposit rates o f informal lenders

and concludes that the spread is la rge ly accounted for by lender 's

opportunity cost o f funds. However, no e x p l i c i t decomposit ion i s

attempted. On the basis (if data in the report and cert i tn assumpt Ions,

a 'Bottomley' decomposition o f interest rates Is therefore estimated

here. Details o f aoneylenders finances and the decomposition along

with assumptions underlying the estimates are given in Table 15.10.

15.5.5 According to this decomposition, 65 per cent o f the to ta l loan

interest rate Is accounted for by deposit cost and opportunity cost o f

funds. However, the estimate o f loan interest is based on interest

rates reported by lenders. To the extent that funds l i e Idle for a part

o f the year, the estimate w i l l be biased upward; but to the extent that

lenders underreport their Interest rates, and there Is evidence in the

report that th is was done, the es t imate i s biased downward.

Never the less , the economic rent element Is u n l ik e ly to overshadow

opportunity and deposit cost even i f earnings are underestImated. I t

should also be noted that imputed cost o f moneylenders time Is not

accounted for. Singh (1967) attempted a decomposition for a sample o f

seven lenders o f a v i l l a g e in Punjab. According to his es t im a te ,

opportunity cost o f funds accounted for 54 per cent o f interest charged

while monopoly p ro f i t accounted for 6 per cent o f the Interest . Even

though h is sample Is fa r removed In time and space, the es t im ates

support the contention In the CDS report that high Informal Interest

rates do not necessari ly r e f l e c t usury.

15.5.6 This Is not to say that informal lenders are uniformly non-

exp lo i ta t ive . Evidence provided by, among others, Roth (1979), Bhadurl

(1977) and Sarap (1986) suggests that monopoly rents may be Important in

some contexts and areas, though not for professional moneylenders in the

area studied by the CDS.

15.6. Impact of rural informal credit markets on allocative efficiency and equity

15.6.1 There can be l i t t l e doubt that Informal lenders are more

functionally e f f i c i e n t than formal Intermediaries. In the study areas,

and general ly , the hypothesis that they raise the average e f f i c i en cy o f

f in a n c ia l In te rm ed ia t ion ( th a t i s , reduce the average cost o f

Intermediation) f inds support. The data In Table 15.10 and other

evidence in the report may be c i ted in corroboration.

15.6.2 Again, since Informal loaas generally go to the highest bidder

within the confines of the ir fragmented markets, the presumption Is that

a l lo ca t i v e e f f i c i en cy Is raised in comparison with a lower leve l of

Informal loans, whether loans are used for production or consumption.

Even I f the narrow view is taken that consumption loans reduce the

e f f i c i en cy o f credit use, Table 15.11 shows that about 70 per cent o f

net Informal c r e d i t is taken f o r p roduct ive loans or fo r housing

Investment. Of course, the fu n g ib l l l t y o f credLt must be kept in view

when makLng this d is t in c t ion a point stressed by Bhende (1983) for his

sample o f v i l l a g e s . Thus, even though Informal lenders In the study

area are not very ac t iv e In mobilising deposits, the presumption Is that

informal markets Increase a l loca t ive e f f i c i en cy .

15.6.3 The presumption gains in attractiveness when the fact that

Informal agencies provide the bulk o f c red it to asset poor households,

both In the study area and at the A l l - Ind ia le ve l (CDS (1988), Chapter

6) is taken into account. Consumption loans to the poor can c lea r ly by

e f f i c i en cy (that Is x - e f f l c i en cy ) Improving.

15.6.4 That Informal c r e d i t i s the main c r e d i t source o f poor

households in both the study area and nat ional ly is su f f ic ien t evidence

that Informal c red it Increases the welfare o f the poor. Kucup (1976)

and Bhende (1983) also find that informal c red i t is the main source o f

cred it for poor households. Since, informal c red i t also goes to the

r ich, the ultimate impact on the d is t r ibu t ion o f income and wealth

cannot e a s i l y be in f e r r e d . What is c l e a r is that in formal c r e d i t

aarkets lead to g r ea te r e q u a l i t y Ln the d i s t r i b u t i o n o f c r e d i t to

households. However, i t may be the case that cheaper credit w i l l lead to

a further increase in the equity impact o f cred it provision while not

necessari ly improving resource a l loca t ion . Thus, while i t is d i f f i c u l t

to support regulations which suppress informal markets, competition from

formal c red it - provided such cred it can compete with informal c red i t ,

is l i k e l y to have a pos i t ive impact.

15.7. Conclusions

15.7.1 One feature o f the picture o f informal credit that emerges

from the preceding d iscuss ion is s t r i k in g . That is d i f f i c u l t t j

reconcile the decline in the r e la t i v e size o f the rural informal cred it

market despite i t s dynamism and e f f i c i e n c y espec ia l ly when the l a t t e r is

compared with the performance o f formal c red i t - One hypothesis wh Ich

f i t s these findings and also findings by e a r l i e r writers on explo itat ion

by informal lenders is that the spread o f formal credit inst i tut ions,

however poor their services and however skewed the ir loan po r t fo l io s ,

has lead to a decl ine in the a b i l i t y o f informal lenders to extract

rents because o f the e f f e c t s o f competition. However, regulation o f

informal intermediaries could also p a r t i a l l y explain this decline (as in

the case o f finance companies). The v e r i f i c a t i o n o f th is hypothesis

must await further study.

15.7.2 Whatever the real explanation, i t is c lear that rural c red it

markets have undergone a sea change at least in the study areas. I t is

also reasonably c lear that the poorest have been l i t t l e a f fec ted by

these changes and continue to r e ly on t rad i t iona l cred it sources since

they do not have su f f i c ien t access to the newer sources- In c los ing,

the l imited coverage o f the CDS f i e l d survey should be reLterated.

Except when corroDoracLve evidence is forthcoming at the national l e v e l ,

the findings o f the CDS study should not be taken to necessarily r e f l e c t

the situation in the rest o f India. ^

Since t h i s study was prepared an important study by Raraakrishna (1989) on agr icultural labour In one d i s t r i c t of Orissa has appeared. His major conclusion is that s l i gh t ly more than h a l f the in formal loans to them are nonexploitat lve.

Trends la Aggregate Cash Dues Outstanding la Rural India

Item 1961 1971 1981

Rs Per c r o r e cen t

Rsc r o re

Perc e n t

Rsc r o r e

Per c e n t

A. AGGREGATESI . Current p r i c e s 2788. 93 _ 3652 .10 _ 6006.23 _

2. 60-61 p r i c e s 2788.93 - 1954.12 - 1220.78 -

B. GROWTH DURING DECADE1. Current p r i c e s 963 .07 34 .53 2254.23 6 0 .0 92. 60-61 p r i c e s - - ( 8 3 4 .8 1 ) (2 9 .9 3 ) (7 3 3 .0 4 ) (3 7 . 53)

C. 1. PER HOUSEHOLD (R S .) 406. 30 - 48 7 .05 - 661 .00 -

2. PER REPORTING CULTIVATOR 393.00 - 1330.00 - 1595.00 -

D.

HOUSEHOLD (R S .)

DEBT - ASSET RATIO - 7 .87 - 4 .3 0 - 1.83

E. AGENCYVISUI. t 'oraal 413. 44 r * .3 o 999.41 23.41 367",. 00 61. 202. In form al 2375.48 85. 20 3270.06 76 .59 2330.21 38 .80

2a. Landlord 25.03 I . 1 324 .05 12. 2 242.59 10. 2

2b. A g r i c u l t u r a l 1281.03( 0 . 9 )53 .9 8 6 7 .1 5

( 4 . 5 )3 2 .6 523.07

( 1 - 2 ) 2 2 .1

moneylender 2 c . P r o f e s s i o n a l 415.90

( 3 2 . 0 )1 7 .5 517.16

( 1 0 . 7 )20 .0 504.13

( 2 . 6 )21 .3

aone y le n d e r 2d. Trader 213.98

( U . l )9 .0 325 .07

( 6 . 5 ) 12. 2 207 .15

( 2 . 0 )8 .7

2e. R e l a t i v e / F r i e n d 190.02( 7 . 0 )

8 .0 518.80( 4 . 9 )19 .5 533.62

( 1 . 0 )23 .4

2 f . Other 248.87( 8 . 3 ) 10. 5 105. 52

( 8 . 8 )3 .9 3 38. 58

( 2 . 9 )14 .3

HOUSEHOLD TYPES Proportion o f Households1. A l l r u r a l h o u se h o ld s

( 1 5 .0 )

6 2 .8

( 1 - 4 )

4 1 .3

( 1 . 6 )

2 0 .02. C u l t i v a t o r s - 6 6 .7 - 4 4 .4 - 22. 33. N o n - c u l t i v a t o r s - 52 .0 3 3 .6 12.4

N otes : f . N eg at ive f i g u r e s Ln paraenthesus f o r ( B ) . S ou rce : T ab les 2 .3 , 2 . 5 , 2 . 6 , 2 .7 , 2 .92. P ercen ta g es tn p a ren th eses are p r o p o r - 5 .4 o f CDS R eport ,

t l o n s o f h o u s e h o ld s f o r ( 2 ) .

Statewise Details o f Cash Dues Outstanding

State Cash dues outstanding Share o f Informal agencies(Rs per reporting in aggregate cash dues

household) (Per cent)

1962 1971 1981 1962 1972 1982

1 . Punjab 1288 3118 9580 89.3 64.0 25.82. Haryana - 3394 13048 - 73.6 24.23. Himachal Pradesh - 1501 3077 - 76.1 25.54. Gujarat 367 2331 5022 76.3 53.1 30.05. iJttar Pradesh 482 971 2752 89.1 76.6 44.96. Maharashtra 700 1477 4241 53.6 32.6 13.67. Jammu & Kashmir 3 91 751 2995 90.4 79.6 56.58. Bihar 599 840 1744 94.9 89.3 52.89. Karnataka 975 1707 5715 83.9 70. 3 21.810. Rajasthan 1026 1617 4932 95.4 90.6 59.111. Kerala 414 1108 3 409 82.5 55.6 21.412. Madhya Pradesh 660 1055 3005 84.3 63.4 3 3.713. Andhra Pradesh 912 165 5 4055 90. 5 86. 3 59. 114. Tamil Nadu 1081 1850 3911 86.5 77.9 55. 715. West Bengal 425 k623 1677 76. 7 69.4 35.416. Assam 330 758 1113 76.2 65.3 69.417. Orissa 392 583 1803 73.6 70.0 18.1

ALL INDIA 393 1330 3 595 85. 2 70.8 38.8

Note: 1. States arranged according to descending Source: Tables 2.9 & 2.11value o f per household assets in 1981. o f CDS Report.

Demographic Characteristic (1971) and Sample Design of Villages in CDS Sample (1988)

Item State/Vil lageKerala Tamil Nadu

Anikad Ezhu- kone

Th tao- navaya

Thai i - kul am

V Li- pat t L

rtookuper L

Area: Km 22.18 15.77 10.93 10.89 7.15 4.87

Population 11877 18661 13376 16751 7535 3373

Sex rat io (F&M) 963 999 1078 1158 93 3 1349

No. o f households 2026 3959 2021 2622 1663 629

SAMPLE HOUSEHOLDS

Cultivators 17 14 29 31 21 1L

Other self-eraployed 8 21 3 1.7 6 54

Salary earners 1 9 6 16 1 1.3

Agricultural/casual labour

26 19 29 26 4 3 5

Skil led labour 6 I 2 1 4 2

Total 68 83 77 95 76 79

Notes: a. Saraple households in Kerala were further Source: CDS Report Tables t r a t i f i e d on the basts o f monthly income,

b. Sample households in Tamil Nadu werefurther subdivided on the basis o f source o f income (agricultural/non-agricultural ) and s ize o f land holding.

4.1 & Appendix 2.

C haracteristics o f Aggregate Cash Dues fo r Saaple V illages

A. TOTAL OUTSTANDING LOANS•Vnount('000)

I? o f -sta­p le house- ho Id s Indebted

Loans per househo Id ( a s )

Loans per re p o r t in g houshold (Rs)

1. Formal c r e d i t 1540.832. In fo rm a l c r e d i t 387.44

2 .1 A g r i c u l t u r a l m oneylenders 15.01( 3 .8 7 )

2 .2 P r o f e s s i o n a l m oneylenders 45.61(1 1 .7 7 )

2 .3 T ra d ers 1-88( 0 . 4 9 )

2 .4 R e l a t i v e s / F r i e n d s 324 .9(8 3 .8 6 )

40 .5816.32

3223 .50810.54

7942.444967.15

BORROWINGS BY OCCUPATION (Z )C u l t l v a -v a t o r s

69. 70 10. 30

Other s e l femployed59.82 40. 18

S a la r ye a r n e r s

57 .8842. 12

A g r l / casual lab our 46 .51 51. 19

A l l non c u l t i ­v a t o r s 66. 99 U . 01

C. INFORMAL LOANS BY SIZE OF LOANI . S ir e c l a s s ( ^ s ) 0 -500 501-

1500 24 .47 2 7 .66Per c e n t o f loan

1501-250011 .70

2 501- 5000 21. 28

5001-100008.51

Above100007.45

D. INFORMAL LOASS BY SECURITY1. S e c u r i t y Personal Cold2 . Pf>r c en t o f lo a n s 40.0f> 17 .17

L a n d /3 u i ld ln 3 Others 3 7 .05 5.42

8. INFORMAL LOAMS BY DURATION1. O j r a t l o n (raonths) 1 -6 6 -12 12-24 24 -36 36 -60 602. Per c e n t o f l o a n s 39. 36 20.21 1 .06 6 .3 8 1 .1 9 29 .79

Average Corre lation Across V illa g e s Between Loan Size and Duration: 0.24

F. INFORMAL LOANS BY INTEftKST RATS (Z PER ANNUM)1. Ilanae o f I n t e r e s t 0 0 -6 6 -12 12-24 24-36

rate s2. Per cen t o f l o a n s 28 .96 0 .6 8 1 .3 7 8 .2 7 27 .58

36 -60 60 4above 30. 343 .4 4

S ou r c e : T ab les 5 .5 , 5 .6 , 5 .9 , 5 .1 0 , 5 .13A, 5 .14A, 5.15A, 6 . 4 , Page 114 o f CDS Report and Computation.J

Interest range

0

1 -6

6-12

12-24

24-36

36-60

Above 60

Average Interest rate (% p-a . )

Professional raoneylenders

Agriculturalmoneylenders

1.14

1.14

N i l

7.95

37. 5

3.41

48.86

51.86

N i l

N i l

Nil

18. 18

72. 72

9.09

N i l

29.45

Friends and re la t Ives

97. 96

Nil

Nil

N i l

N i l

N i l

2.04

3 - 28

Note: Traders in 2 v i l l a g e s g ive interest Source: free loans. In another v i l l a g e the loan interest rate from traders averages 13.33%. In a fourth v i l l a g e one loan at 60% was reported.

Tables 6.1, 6.2, 6.3, pgs. 130- 131 o f CDS Report and conput.it Lons.

Distribution o f Financial Assets of Sample Households

Credit agency Beginning of year End of year

Amount Per cent Amount Per cent

Formal sector 100 90.59 235.00 94.32

Informal sector 7.49 6.78 10.23 4.10

Chit funds 1.60 1.45 3.26 1.31

Professional moneylendrs/ 1.30 finaneers

1 .18 0.66 0. 26

Note: For amount: Formal sector deposits Source: Table 8.3 o f CDSat beginning of year=lOO. Report and compu­

tation.

TABLE 15.7

Case Studies of Rural Inforaal Lenders

SI.Type of lender No.

0*nfunds

Sources of funds (X)

Deposits

Pr0S others F4R

Other

Deposit interest il p.a)

Loan interest a p.a)

No. of loans

Annualturnover(Rs)

(1) (2) (3) (4) (5) (6) (7) (8) (9)

1. Moneylender 180 Eaerqency Otheraoneylender

N.A. 320i 28/week)

105 14000

2. Faraer-trader- noneylender

100 • ” Arecanut N.A. whole­saler

About50

8 7400

3. Farser- K-neylender

100 - - - ii Knii t - -l

13 2 lakh

4. Faraer- •tcneylender

100 - - -30

N.A. 25 lakh

5. Finance Co. (Prop.}

N.A. Rs 4lakh

- 12-14 24 N.A. N.A.

6. Finance Co. (Prop.!

N.A. Rs 22,000 - - 10-13 24 N.A. 2-2.5lakh

7. Finance Co. (Prop.)

Mainly - 12 24 N.A. 26 lakh

8. Finance Co. (15 partners)

Rs 3 lakh

Rs 21 lakh

- 10-12.5 18-30 N.A. N.A.

9. Faner- aoneylender

Rs 2.5 lakh

Rs 4.5lakh

- 24 36(Ave.)

100-150 19 lakh

li.Faner-aoney- lender (4 cases)

N.A. N.A. N.A. Coop.banks

- 36-60 upto 75 N.A.

11.Rubber traders (8 cases)

100 Coop./coaaer-cialbanks

N.A. 0 N.A. 5-23lakh

(1) (2) (3) (4) (5) (6) (7) (8) (9)

12.Finance Co. (4 partners)

Rs 1.5 Rs 18lakh lakh

12-24 8-46 N.A. 19 lakh

13.Farter-soneylenders

Rs 10,t N.A. 36 154 N.A.

14.Far«er-•oneylender

1.75lakh

Honey- 24 lenders

301:long N.A. 508 (or 3.5/Meek); short

2.4 lakh

15.Farier- soneylender

N.A. N.A. N.A. N.A. N.A. 10 N.A. N.A.

16.Finance Co. 0.5 lakh

24-90 N.A. N.A.

17.Far»er-aoney- 50,8 lender-trader

Credit 18purchasefro«wholsalers

24-36 N.A.15008

18.Vegetable trader

N.A. N.A. N.A. N.A. N.A. in kind N.A. N.A.

Cut Studiti o( Ruril Infonal Lindtri

Si .Clien- No.tele

Loansize(Rs)

Jura­tion(neeks)

Security Bad debts I! of

No. of eiploy- ees loans/I ofborroners)

3alarv (Rs. p.a)

Prenses Landholding/other

Retarks

incoie(Rs.)

ill (2) 13) (4) (5) (6) 171 18) (9) (18)

I. SF,ST,AL 301(ave)

upto 18 None N.A. None None Hoie None Collection of »eekly pav- ient personally froi house to house

2. Arecanut fariers

upto1881

28 to 26

None N.A. N.A. N.A. N.A. 3.25/15,888

(a) arecanut trader, (b) repayment by delivering of arecanut beloa larket price.

3. N.A. 588-35811

N.A. None if land

Increa­sing

None Hoie Hoie 18.9/58.888

*

4. k'r. awn oersons

2228a.ei

N.A. l o a ’1

;ii8N.A. Se n e Ncne Hcie - netirsd Gcwt. servant

5. 3F.AL.FI N.A. N.A. - li/4 5 43.888 Rented -

6. SF,ftL,FI 51-1888

N.A. gold/none

28/5 2 78818 Rented -

7. N.A. N.A. N.A. N.A. 1/1 N.A. 18888N.A.

N.A. -

3. 3F.FI N.A. 13-52 gold/none

N.A. 5 18.888 Rented -

9. SF N.A. 13-32 gold/none

N.A. N.A. N.A. Rented (Rs 6888 p.a.)

4 Rubber cultivation

18.3F.AL Upto5881

13-426 gold/land/none

N.A. N.A. N.A. N.A. 3-15/7888-38.888

11.Rubber N.A. 1-4 None N.A. N.A. N.A. N.A. N.A. Loan reoaid in kind byfariers prior arrangement.

(11 (2) (3) («) (5) (61 (7) (31 (?) (10)

12.N.A. 21 to 2 lakh

26-150 None N.A. 6 36, H i N.A. - Zero interest loans (or poor borro»ers.

13.SF,ST,AL 51 to 2000

13 (ave) None ia/4 - - - N.A.

14.N.A. N.A. 2-3 Sold 6-7/N.A.

N.A. N.A. N.A. 5/N.A. Claits high defaults froi farters

15.ST.AL 50-2000 N.A. golddurables

N.A. N.A. N.A. N.A. 5/(2irri­gated

U.SF.ST.AL N.A. N.A. N.A. N.A. N.A. N.A. N.A. - Coies froi neighbouring town each friday.

17.SF,ST,AL 50-201in kind to SF

N.A. N.A. N.A. N.A. N.A. N.A. N.A. Interest taken in advance

18.Vegeta­blerariers

500-1000 Cropseason

SroHingcrop

N.A. N.A. N.A. N.A. N.A. Repayient in kind belon larket price potatoes: Rs 4 per bag turnip: Rs 2 per bag beans: 10)1

Notes: SF: Stall farters. Source: CDS Report, Appendix to Chapter 5.ST: Stall traders AL: Agricultural labour FI: Fisherien

(Average Interest in per cent per annum)

V i l lage Security

Personal Gold Land/ Other Buildings

Anikad 62 36 361

Ezhukone - 30 -

Thirunavaya 124 35 -

Thalikulam 93 28 -

V i lpa t t i 65 - 0l

Mookuper i 24 - -

Note: 1. One observation. Source: Table 6.11 o f CDS

D eta ils o f Cred it from Pro fessional Moneylenders

A. LOANS CLASSIFIED BY OCCUPATION GROUPS

Group C u t t l - Other S alary \ j r i c u l - Othersv a t o r s s e l f e a r n e r s t u r a l a

employed o th e rlab our

1. No. o f l o a n s ( Z ) 1 3 .4 8 26 .97 4 .4 9 4 2 .7 0 12 .362. Amount ( Z ) 3 8 .73 26 .63 5.44 13 .57 12.213. I n t e r e s t r a t e s 21 -40 N.A. 30 28-125 N.A.

B. PURPOS8WISE CLASSIFICATION OF LOANS

Purpose P rod u ct ­ House c o n s t r u c t io n . / Consunp- Otherion repaIr t Ion

1. No. o f l o a n s (%) 27 .55 8 .1 6 55 .11 9 .1 82. I n t e r e s t r a t e (Z p . a . ) 50 .00 22 .00 84 .57 64 .67

C. INTEREST RATES AND SIZE OF LOANS (RS. )

1. S lse 0 -500 500-1500 1500- 2500- 5000- Above2 500 5000 100002 1000002

2. Average Lntarest 33 41 44 43 3 6 24

0. ASSET GROUPS AND L0A3S

A sset jr o u p ( Rs ) \vera>je loan V /erage Lnt.;- " ir tu lat i .ve p r o p o r t is Lze r a t e (Z p . a . ) o f c r e d i t

1. 0-5000 799 .84 50 10 .232. 5000-10000 116.67 120 10.793. 10000-15000 633 .37 35 12.314. 15000-20000 285. 91 71 13.915. 20000-30000 6 6 3 .00 104 21.936. 30000-50000 652 .50 58 27 .157. 50000-100000 1267.83 48 41. 348. 100000 and above 407 5 .0 0 3) 100.00

8. INTEREST RATE VERSUS SECURITY

1. Secur t ty P ersonal GoLd Land/Bu l ld t n g Othei2. Average In te r e s t 95 29 0* 36

(Z p . a . )

P. AVERAGE INTEREST RATS : 51.86 Z PER annumSHARE OF INFORMAL LOANS: 11 .77Z

N otes : 1. Range o f v t l l a g e w ls e a v e r a g e s . 2. Oae loan each .

S ource : Chapter 6, CDS Report and ccxnputat ton.

Item Rs'000 Percentage o f loan Interest

Basis

1. Total loans 14820.90 - -

2. Total deposits 2488.82 - @ 16.79% o f (1 )

3. Own funds 12331.98 - (1 ) - (2 )

4. Loan Interest 4046.27 100.00 @ 27.30 % ( I )

5. Deposit interest 437.45 10.81 @ 17.5% o f (2 )

6. Administrative cost 205. 51 5.08 @ 1.39% o f (1 )

7. Opportunity cost 2219. 76 54.86 @ L8% o f (3 )

8. Default cost 943.35 23.31 @ 5% o f (1 ) + (4 )

9. ^cononLc cent 240.20 5-94 (4 ) - (5 ) - (5 ) - ( 7 ) - ( 8 )

Note: 1. Sample s ize : 4 Source: Tables 6.8, 6.12 and 8.4 o f Report and2. Percentages used are Computations,

averages across reporting lenders.

Purpose Amount Share o f to ta l(Rs'OOO) for ( l ) + ( 2 ) + ( 3 )

1. Production 142.70 27.07

a. Cultivation 30.65 5.81

b. Non farm business 112.05 21.26

2. Cosumption 166.15 31.52

3. Construction/repair o f houses 213.27 41.41

4. Repayment o f debts 64.80 10.95

Source: Table 3.10 of CDS Report.

POLICY

PART E

PRESCRIPTIONS

LESSONS FOR FORMAL FINANCE AND AN APPROACH TO THE REGULATION OF INFORMAL INTERMEDIARIES

16.1 Lessons for formal banking

16.1.1 Spec i f ic recommendations are given in the coarse o f case

studies fo r changes in current bank practice and lessons which the

formal sector can pro f i tab ly learn from Informal Intermediaries.

Here we wish to propose an overa l l strategy o f formal banking

development.

16.1.2 Though there are problems, the formal sector serves, by

and large, the needs o f organised and large sc&le production.

Banking needs o f the government and o f sa lar ied, urban, households

are also wel l served. Where bank service f a i l s Ls in serving the

needs o f the small entrepreneurs and the trader. Furthermore

banks are c lea r ly less successful in serving the needs o f the

poorer sections as a whole (a t least upto 1981-82 when the RBI

Debt and Investment Survey was conducted). For such loans,

defaults and overdues are also a major problem, though spec i f ic

de ta i ls are not ava i lab le (but see Nayar (1987)).

16.1.3 Since i t has been concluded in the case studies (subject

to the usual caveats as to adequacy o f In format ion ) that the

Informal sector is both better at serving the sectors neglected by

banks and also recovering advances from these sectors, a pol icy of

encouraging informal credLt with, however adequate safeguards

against fraud and exp lo i ta t ive pract ices (see below) suggests

I t s e l f . In a sense, banks should relinquish areas o f business

where they do not have an absolute (o r even comparative )

advantage. Instead re f inance f a c i l i t i e s f o r Informal

Intermediaries and even perhaps, to traders channelled through

t raders a s so c ia t i o n s appear a t t r a c t i v e . T i l s Is what we

recommend.

16.1.4 Regarding s p e c i f i c in n ova t iv e schemes fo r se rv ing

depositors and borrowers, while a few suggestions have been made

in the case studies, banks in India, are by and large, Innovative

enough In serving those sectors where they have an advantage.

16.1.5 Regarding other formal f i n a n c ia l markets i t Is worth

c i t in g the result o f Cho (1985). He finds that Increased equity

f inance through a strengthened stock market has p o s i t i v e

a llocat ion e f f e c t s in a s i tuat ion o f assymetrlc Information as to

borrower risk-

16.2 Fraud, Information and the regulation o f Informal intermediaries

16.2.1 One way o f ensuring that no fraudulent organisation has

access to deposit money Is by banning informal Intermediation

altogether. Tie cons Id era t Lon o f this poss ib i l i t y , while not

being suggested as a serious po l icy neasure, has the merit o f

throwing the consequences o f over ly r e s t r i c t i v e regulation Into

sharp focus. I f such an a l te rnat ive was enforceable, then those

with financial saving would be restr ic ted to formal sector saving

In s t i t u t i o n s and equ i ty markets. However, It is l i k e l y that

informal Intermediaries can tap large reservoirs o f public saving

even a f t e r su b s t i tu t ion between formal and in formal saving

Instruments Is accounted f o r . High in t e r e s t , persona l is ed

serv ice, deposit s o l i c i t in g agents and informality o f dealings and

Innova t ive saving schemes a l l make th is l i k e l y . Further,

deposits so mobilised, amounting to a sizeable amount In absolute

terms, find theLr way Into the formal sector, part icu lar ly the

government sector. Thus, development o f the financia l sector and,

In particular, the substitution o f f inancia l for non f inancia l

saving would suffer I f informal intermediaries are banned. The

point here i s that c e r t a in in formal in te rm ed ia r ie s have an

absolute advantage In mobil iz ing deposits from part icular segments

o f the saving public. Secondly, certa in Lnfonnal Intermediaries

have an absolute advantage la ensuring the recovery o f loans made

to p a r t i c u la r segments o f in ves to rs . Banning a l l informal

intermediaries w i l l thus result in f inancial constraints being

faced by a section o f firms or, i f they get formal accommodation,

w i l l result In raising the aggregate r isk o f formal sector loan

po r t fo l io s . The e f f i c i en cy o f f inancia l intermediation w i l l be

a f fec ted In either case. Thus, regulations which put (p a r t ia l or

t o ta l ) quantitative r^str le t ions on the deposits which an informal

intermediary can mobilise should be made only a f te r care fu l ly

weighing the costs and benef i ts . This may be taken inter a l ia as a

c r i t i c ism o f the Prize Chit (Banning) Act o f 1978. In fact , that

money c irculat ion schenes or prize ch i ts , even i f they have no

loan p o r t fo l io , should be banned i s open to debate. What Is not

at issue Is that fraudulent Intermediaries such as a section o f

blade companies or as described in the Raj Committee Report (1975)

should be wound up.

16.2.2 Is there any a l te rnat ive to quantitative restr ic t ions on

deposits? One poss ib i l i t y that merits further examination is the

l icensing o f deposit taking firms and periodical review o f the

operations o f the f l ras by licensing authorities. A further

measure is to make prior ve t t ing o f deposit acceptance schemes

(including provisions re lat ing to penalt ies, for fe i ture e t c . ) by

regulatory authori ties compulsory. Both these measures w i l l o f

course require a much more sophisticated monitoring and review

procedure on the part o f the Reserve Bank than now appears to

e x i s t . Thus a ca re fu l enquiry into the reasons for the

ine f fec tual handling o f for example the Sanchaita and Peerless

cases and appropriate remedial action are ca l led for.

16.2.3 While the measures outlined in the previous paragraph

would, i f properly implemented, ensure that fraud and para l le l

market transactions are curbed, depositors may s t i l l be misled by

aggressive and Inaccurate promotion campaigns. In a la rge ly

rural and r e la t i v e l y backward economy l ik e Ind ia 's , the e f f i c a cy

o f any measures to prevent such practices i s bound to be l imited.

S t i l l , e f f o r t s can be made to inform savers as to the

attractIveness o f d i f f e ren t saving schemes by inst i tut ing a method

for ratLng d i f f e r en t saving schemes- The rat ing can be based on

scheme d e ta i l s , the intermediary's loan p o r t fo l i o and i t s past

performance. These ratings can then be given wide pub l ic i ty .

Armed with a rating chart and a l i s t o f l icensed interned Lar ies,

even a person with l imited training or sophistication could serve

as a competent f inancial adviser. Addit ionally , firms may be

compulsorily required to supply certain Items o f Information to

depositors at periodic in terva ls . Similar rules could also be

la id down for advertisements by financia l firms. Loan schemes and

lending pract ices should be subject to s imilar vet t ing as has been

suggested for deposit schemes.

16.2.4 The k inds o f measures ou t l in ed above along with a

ca re fu l ly thought out monitoring and inspection scheme should help

contain fraud and improve the informational e f f i c i en cy o f Indian

f inancial markets. Furthermore, once the Reserve Bank lays down

appropriate ju lde l ines bas-;d on wh Lch decisions on Ae ther to

allow or disallow any intermediary, deposit scheme or loan scheae,

the need fo r m u l t ip le ( c u r r e n t l y fou r ) s e ts o f d i r e c t i o n s

governing d i f f e r en t types o f non-bank f inancia l Inst i tut ions w i l l

disappear thus result ing In simpler laws.

16.2-5 The discussion In this section has been motivated by the

need to foster and not fe t te r a healthy f inancia l market while

ensuring that fraud Is prevented and that savers and borrowers are

we l l Informed about the var ious products a v a i l a b l e in the

financial market. A presumption underlying the discussion is that

Informal In te rm ed ia r ie s , i f and when they become i n e f f i c i e n t

r e la t i v e to the formal sector in the segments served by them, w i l l

die a natural death. Furthermore, natural death In this s i tuation

Is p r e f e r a b l e to death or c r i p p l in g by r e g u la t i o n . The major

a f f l i c t i o n that has been im p l ic i t l y Iden t i f ied as the main reason

for e v i l s discussed In a few case studies Is the poor Information

environment. Accordingly the remedy proposed deals almost en t i r e ly

with Improved information flows.

16.2.6 I t Is c lear o f course that a poor information environment

is not the only problem to be addressed In e f f e c t i v e l y regulating

the informal f inancial market.. Other features revealed by the

case studies are the suspected nexus between the p o l i t i c a l

establishment, the Informal f inancial market and the underground

economy; the d i f f i c u l t y and delay in gett ing regulatory moves

upheld by the courts; the lack o f coordination between d i f f e ren t

regulatory bodies; and the interaction between d i f fe ren t types o f

government regulations which combine to create opportunities for

f inancial explo itat ion by some agent (such as in the dockyard

financiers case study). While spec i f ic recommendations have been

made on a case by case basis, we nevertheless be l ieve that the

major problem is the Informational problem dealt with In this

chapter.

16.2.7 Regarding Interest rate regulation, In one case, chit

funds, the c e l l in g prevai l ing on Intecest rates (through bidding

c e i l i n g s ) appears to be i i r r a n e 1 ri 11 .should be l i f t e d .

However, given the p i t f a l l s in hasty f inancial l ib e ra l i s a t ion , as

i s seen from the La t in American exper ience , i t would be

inappropriate to make a recommendation on interest rates without a

careful pol icy analysis.

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CONTENTS OF "URBAN INFORMAL CREDIT MARKETS IN INDIA"

Preface

Acknowledgeraents

SUCTION I: ASPECTS OF URBAN INFORMAL CREDIT IN INDIA

PART A : I- Overview

PART B : Description o f Indian Informal Credit and Informal Credit Markets

2. Informal Credit and Informal Interned tar ies3. Deposit Mobilisation A c t i v i t i e s and Sources

o f Funds4. Uses o f Funds5. Terms o f Loans and Credit Appraisal Methods6. Cost of Intermediation7. Structure o f Informal Markets8. Size and Trends in Size9. Regu lat ion o f Informal T.nt^rmed in i* les

PAR.T C: Analysis o f Economic Impact o f Informal Credit Markets

10. Informal Credit and the Sf fleLency o f Resource Allocation

11. Distributional and Equity Impact o f Informal Finance

12. Are in fomal and Formal Finance Conplements orSubstitutes ?

13. Informal Credit and Monetary Pol icy14. Two Issues: The Complementarity Hypothesis

and Links with the Black Economy

PART D : Policy Prescriptions

15. Lessons for Formal BankLng and Recommendationsfor Regulation

SECTION I I : SECTORAL AND CASE STUDCSS

PART E : Analysis o f Reserve Bank of India Surveys

16. Informal Credit and Household Debt17. In fomal Credit for Small Scale Industry, Trade

and Transport Operators

PART F : Case Studies of Selected Intermediares

18. Auto Flnancers in Namakkal

19. Nidhis o f South India20. Finance Corporations o f South India21. Handloom Financiers. in Bangalore and Karur22. Hire Purchase in South India and Delhi23. Chit Funds in South India with a note on

Community Chits24. Dockyard Financiers in Calcutta25. The Intercorporate Funds Markets

Financing o f Credit Using Sectors

26. Film Finance In Madras27. Garment Export in Delhi28. Informal Credit to the Powerloora Sector29. Road Construction in Delhi and Western Uttar

Pradesh30. Informal Finance in House Construction

31. T ex t i l e Trade in India

PART H : Case Studies la Regulation

32. Shroffs o f Western India33. The Sanchaita and Peerless Cases

APP2KDIX:Indi^jeneous Financial Inst i t ut Ions: \ 3iC\/ey of the Literature

BIBLOGRAPHY

CONTENTS OF "THE INFORMAL CRKDIT MARKETS IM RURAL ISDIA"

Chapter

Ch apt er

Chapter

Chapter

Chapter

Chapter

Chapter

Chapter

Chapter

Chapter

1 In trod uction

2 Size o f Informal Credit Markets

Appendix I

3 Interregional Variations In the Size of Formal and Informal Credit Markets

4 The Study Areas

Appendix 2

5 Structure o f Informal Credit Markets

Appendix 3

6 Interest Rate Formation in the Rural ICMs

7 Factors Underlying Interest Rates Variation In the Sample V i l lages

3 Role o f Informal " o ^ K t Markets: Savings Mobilisation, A l loca t ive E f f ic iency and Equity Impact

9 Alternative Approaches to Informal Credit Sector

10 Summary and Conclusions

Re ferences

PREFACE TO THE CDS REPORT ON INFORMAL CREDIT MARKETSIN RURAL INDIA

The Asian Development Bank had commissioned a comparative study o f Informal Credit Markets in a few selected countries in Asia. The country study on India was j o in t l y undertaken by the National Inst i tu te o f Public Finance and Pol icy (New Delh i) , and the Centre for Development Studies (Trivandrum). The former took up the study o f the urban informal cred it markets, and we, at th is Centre, covered the rural sector. The present volume incorporates the findings o f our invest igat ion o f the informal credit markets in rural India.

The over a l l coordination o f the work on the project was entrusted to a study team comprising Professors T. N. Krishnan,I .S . Gulati, P.G.K. Panikar (Pr incipal Coordinator), Chiranjib Sen and Mr. D. Narayana. Dra f t ing o f the report was done by the fo l lowing: P.G.K. Panikar (Chapters 1, 2, 4, 5, 6, 8, 9 and 10), Ch iran j ib Sen (Chapter 3 and 7) and D. Narayana (Appendix to Chapter 2 ) .

We take this opportunity to express our thanks to the ADB for sponsoring th is study and l ib e ra l f inancial assistance. We also wish to express our appreciation o f the sp i r i t o f cooperation and understanding on the part o f the NIPFP. The unstinting and hard work o f the project s t a f f , espec ia l ly o f Messers Jayaraj, Jose Jacob and Namboodiri are apprec ia ted . The support and assistance from our colleagues at the Centre, the members o f the l ib ra ry and administrative s ta f f in particular are g ra te fu l ly acknowledged. Special mention may be made o f Mrs. G i r i ja who attended to the demanding job o f typing the draft o f the report.

T.N. KRISHNAN